It seems pretty straightforward. You want to make a little extra money, so you put your home up for rent on Airbnb while you’re on vacation. But what liabilities do you face in doing so, and how can you protect yourself with one easy phone call?
It also seems like a simple process to self-direct your IRA and place your rental property in a checkbook LLC. It’s a good way to protect yourself as a landlord, but there are things you must not do if you don’t want to put your entire IRA at risk.
We’ll be discussing these and more on today’s show.
Eric Nixdorf is one of the few real estate attorneys in the country who specializes in tax law, bankruptcy, and real estate. He’s also a real estate broker and an investor himself.
It’s been a long time since we spoke, and since I love getting free legal advice, I thought I’d invite him back as a guest.
Podcast Transcript: How to Protect Your Rental Properties and Yourself
Kathy Fettke: Eric, welcome. It’s great to have you here.
Eric Nixdorf: Thank you very much, Kathy. It’s great to be here.
Kathy: Well, you are one of those attorneys who can really cover it, I don’t want to say cover it all, but cover a lot of things that real estate investors need to know, because you specialize in tax, bankruptcy, real estate, and you’re a licensed real estate broker. I’m just really honored to have you back here on the show.
Eric: Thank you very much, again, it’s great to be here.
Kathy: What would you say– Is there anything new that real estate investors should be aware of in terms of tax law?
Eric: Well, one of the things this new tax reform that went into effect, where in certain businesses, you get to exclude 20% of your income, in some real estate investments, you can take advantage of that. The biggest plus of real estate investing though is still in effect, which is your ability to take depreciation deductions, which are a non-cash expense and against the property against its earnings. That allows you to basically get tax free income coming in on an investment property, and a 1031 exchange loss that are still in effect allow you to trade properties without having to realize the taxes. You theoretically could buy a piece of property, refinance it, eventually trade it to another property. If you hold it, if you are in a community property state like California and you’re a couple and you hold it until one of you passes, the other one gets that property with a stepped-up basis and can basically sell it tax-free. If you bought it 20 years ago and you exchanged it and you held it as long as until one of you passes, you basically escape taxation on that entire amount of gain.
Tax Advantages for Landlords, Property Owners
Kathy: If you’re a couple and one of you passes?
Eric: If you are a couple. Yes. The community property state, when one passes, the surviving couple gets a stepped-up basis in the entire property. Where you normally have to pay capital gains, you basically erase those capital gains.
Kathy: That’s amazing. I knew that was true for children or anyone who’s receiving an inheritance, that if they inherit the property, it steps up to market value and they don’t have to pay the gain that their parents would have. I didn’t realize that applied to spouses.
Eric: That’s a unique rule in community property states, because in a community property states like California, the entire amount of property is considered an interest in the community. Once one passes, you get that stepped-up basis just as if you inherited it from a child. What I tell a lot of real estate investors is, when you start, you’re really never ever going to want to sell. You may want to trade an exchange, but unless it’s going to be a single-family residence that you use to be able to get that exclusion of the 250 or 500 if you’re married, your best bet is to hold on to that property as long as you can, refinance it when you need cash, and then sell it once you get that stepped-up basis, tax-free.
Kathy: We put our home on the market, and we’ve got a bunch of offers, which was great. We had one of the buyers was selling their home in Northern California, but they had to buy something of the same or less value in order to keep the property taxes the same, I believe is that prop 60?
Eric: Yes, depending on certain attributes of your age, et cetera, there are some ways to keep the property tax reassessments. For those types of issues, it is important, especially if you have children, et cetera, because you can pass the benefit of keeping the property taxes at a certain level. There’s typically age restrictions. The idea that these went into effect was they didn’t want senior citizens basically getting pushed out of their properties solely because of the real estate taxes. That is something you want to look at, depending on your age is, “When I go to sell this property, if I’m planning on buying another one, is there a way I can keep my property tax level at the same?”, because that would be a consideration when you’re looking to replace the property.
Kathy: That was fascinating, because they could sell from high priced San Francisco Bay area, and actually move to Malibu and get a lower priced house because their Francisco’s so expensive these days, but because it was less expensive in Malibu, they could pay the same property taxes they were paying in San Francisco. If they bought the property 20 years ago and they were on a really low tax base, obviously they wouldn’t want to move out if they’d lose that.
Due Diligence: Local Laws and Real Estate Rules
Eric: Yes, whenever you’re looking at purchasing and reinvesting, whether it’s a residence or a rental property, it’s really important to look at the municipal rules, and some places will have these special tax assessments don’t have certain rules of who you can rent to, or how much the increases can be, especially with a place like San Francisco. The further you go away from where you are, the more research you have to do, because the rules, what you may be used to here in California, could be completely different in states, particularly in the South and on the East Coast. Because the real estate systems developed hundred years before some of these places were even states. California tends to be a completely separate system, along with the West Coast, compared to how things go, say, in New Jersey or one of the 13 original states.
Kathy: If people want to learn more about that, it’s prop 6090, which basically allows people who are over 55 to transfer their property tax base, which is a really big deal if you live in California. We decided not to sell the property because we found out that there is a huge Airbnb market in Malibu. We decided we’d rather keep it, and especially when we spoke with our accountant and found out that any personal property that we buy for this business, which is basically a short-term rental business, let’s say we completely furnish it, we can bonus depreciate it. Can you explain that more, how that would work if, what could we write off with that 100% write off in one year if we turn our home into an Airbnb?
Eric: A couple of things. First, with this new tax reform, that’s another great point. They extended the special depreciation rules. This only applies for the federal taxes, but what you’ve said is essentially true. You’re able to expense a certain investment property. For example, you’re furnishing your rental business in a short-term rental business as opposed to taking it over time.
You have to be careful because there are other rules called passive loss rules where if you’re going to generate a negative, basically what would be a tax deduction on a passive investment, you basically have to wait to claim those later. If you’re going to have a high-income property, these new depreciation rules that allow you to expense it like you would a repair cost as opposed to 27.5 years or 5 years.
Basically, how depreciation works is, there’s basically a table you look at for the type of asset that it is you’re buying, and you’re able to expense it over a certain amount of time. If you buy a rental property, it’s 27.5 years, and you’re basically taking a 27.5 off the basis in the building, let’s say. You get that straight deduction every year to offset your income.
Then when you go to sell it, though, you’re going to recapture that depreciation. You don’t escape the tax, but you get a deferment up until when you sell it, and as we’ve talked about earlier, if you do a 1031 exchange and just to keep holding onto it, you’re never going to pay that tax. I will say there’s one thing you have to be very careful about with these Airbnb rentals. That is, if you have a tenant or someone you’re renting out to that stays over a certain amount of time, typically in California, is 30 days, they get basically tenant rights. Rather than easily be able to get them out, you’re going to need to get an eviction lawyer, and I’ve heard horror stories where people end up two, three months. It’s very important that you keep that as short-term rental and get the people out before they’re considered a long-term tenant.
The Risks and Rewards of Airbnb
Kathy: That’s funny you say that. My daughter put her home on Airbnb, because she lives in Chico, and after the fires, there was just tremendous demand of families who needed a home and she thought, “Well, this is a good chance to go travel.” She was able to Airbnb her home and made a lot of money doing that.
One family decided to stay five months, and I literally woke up in the middle of the night one night in a panic because I thought, “Oh boy, as her mother, I didn’t mentor her well, I didn’t tell her that she probably doesn’t have the right lease agreement in place. Now they have tenant rights, and she may never be able to get them out, they could file bankruptcy and never leave.” Anyway, it all worked out and she’s fine. Yes, that is important to understand that after 30 days, make sure you’ve got the right lease agreement, and the right things in place to be able to evict them if you need to.
Eric: Yes, and again, with the Airbnb era, you see a lot of folks that are renting out their homes while they go on vacation somewhere. You have to be very careful from a tax perspective because those rules can be really tricky. You’re able, for a very short term, to rent your house basically out for free without paying any taxes on it, but after you go over a certain number of days, then you’re going to have real potential tax issues. A lot of people forget even to report that income and there you really can run into issues, especially with the services can get subpoenaed or summoned by the IRS to see what records and who was paid what.
Before you start renting your house, you’re going to want to talk to a CPA or a tax attorney like myself, and just make sure you know what the rules are, and keep your calendars of how often you’re renting it out, how many days you’re using the property, because those could come into play if you’re audited.
On the other issue, the questions we get with renting out property, is why use an LLC rather than yourself, or just having it in your name. Because of a potential liability, I always tell where possible, try and put a property in an LLC from the beginning and not rather in your name, because even if you have the best insurance in the world, there are certain things insurance won’t cover. If you faced one of those losses, and you own it personally, you could put everything you own at risk. Whereas the simple way to avoid that is set up an LLC. That way, all your contracts, your leases, everything is in the LLC’s name. If you get in dispute with a tenant, it’s not you being sued or having to sue, it’s an LLC. The only thing that’s going to be at risk is the LLC’s assets, as opposed to your credit, your personal assets. That is something to keep in mind.
How to Get Financing for Investment Properties
Kathy: How would you get financing for that? I suppose you’d have to go to a portfolio lender?
Eric: No, it depends on the lending institution. An LLC, when it’s just you owning it, is something called a disregarded entity for tax purposes. If I own property in an LLC, and it’s just the only owners or myself or myself and my spouse, when we file tax returns, there’s no LLC return. It just goes on my personal return. A lot of banks understand this. It’s similar to having it in a trust. Some banks will make you take it out of the trust to get the refinance, and then put it back in. Other traditional lenders are okay with it. Now, if you’re going to have multiple owners, then you’re probably going to need to go to a more sophisticated lending, but just a single-family residence, banks are used to that now. It’s better to have it from the LLC from the beginning, but you can buy it and then later put it in the LLC.
Just check with your bank before you even take the loan to make sure that you would be allowed to do that without triggering a due on sale clause. You’re not selling the property, you’re just contributing to your LLC, which then you own. What that does is just give you a layer of protection, that if, God forbid, something happens on that property, you’re not personally nor your personal assets are at risk.
Kathy: Good to know.
Covering Your Assets with the Right Insurance
Eric: What I will add to that is, people ask, “Well, what is it that can happen that insurance is not going to cover?” There’s three main areas. One is earthquake. Although now in California, their earthquake insurance rates have come way down. I would encourage people that in the past turned away from getting it because of the really high deductibles and crazy premiums. There’s now a public-private partnership in California, and the earthquake insurance rates are generally very reasonable with a reasonable amount of deductibles, of which that’s changed in the last two years.
Kathy: Oh, that’s so important. Having lived through wildfires, there were people who were not properly insured, and they’re really hurting, and those who were well insured just got a big fat check. I heard that 80% of Californians do not have earthquake insurance, and we know one is coming. [chuckles]
Eric: No, well, when I talk to people that consult with me, they’re not aware that the rates have come down so much, because it used to be purely private insurance companies. Now in California, there’s this public-private partnership, and there is some questions about the funding of it. Should there be an earthquake that is devastating across the state, there could be some payout issues, but provided that the localized earthquake, I think it’s probably worth it.
For example, another issue that we see is, are mold problems. Most insurance policies now will not cover mold. You should check to see if it is. Try and get a policy that will cover mold, because you have any kind of a mold issue and it could be claims of six figures from someone that’s claimed that they were injured from inhaling mold.
Kathy: Oh, wow. Okay.
Eric: Then the last thing to keep an eye out is what we call intentional torts. Most insurance companies will defend you, but they won’t pay punitive damages if there’s any, and you’d say, “Well, I own real estate, what could I possibly do that would be an intentional tort. You would be surprised. I’ll give you an example.
Let’s say that you have a tenant who has a dog, and the dog ends up biting someone and causing severe injuries. If you had knowledge of the dog and any knowledge that it could be a dangerous dog, you could be looking at an intentional tort claim with punitive damages. It’s just important to talk to your insurance company, and just ask, straight out ask your agent, “What can happen that’s not covered here?” Then think about ways to mitigate those. For example, you’re going to have a pet, you’re going to allow pets, have your tenant and make sure they have a pet policy, and put yourself as an additional insured. That way, you know there’s a policy in place in case something happens.
Kathy: Your tenants should have an insurance policy for their pet?
Eric: Yes. What I recommend to clients when they’re renting out property is, I, as a condition of the rental, and again, other states there may be issues with this, but in California, it’s perfectly fine to require your tenant to have renter’s insurance. You can also require that renter’s insurance list you as an additional insured so that if you could file a claim against the tenant’s policy yourself without having to wait for the tenant, and as part of that, you make sure that they have a pet rider that covers, if they’re going to have pets, that there’s special insurance of an amount that you feel comfortable with.
Kathy: Oh, that’s great. That’s such great advice. For people doing the Airbnb thing, like you said, maybe just renting it out while they’re on vacation, do they need to inform their insurance company of that?
Eric: I would check with your policy and check with your insurance agent, because most policies do allow that because it’s becoming a popular thing that we see now. The policies can really vary. Some may require you to get a rider, and it’s just one phone call, and they can get that insurance in place quickly, but if you don’t ask, that can be an issue.
It’s the same as someone’s working on your house. Most insurance policies now will provide, if someone gets injured, say, you hired a contractor to work on your house and they try and do a workers compensation claim against you. Most of the homeowner policies and landlord policies now cover that, so that is something that you want to ask. Before you go down the investor road, you want to be covered and get those questions answered, because you don’t want to be paying these insurance premiums and then find out something is not going to be covered that you could have covered with a phone call.
Kathy: Wow. I’m curious. We had one of our Real Wealth people in Australia, and they’re no longer members, but they tried to sue me, or I should say, Real Wealth Network, and one of our property teams, because the rent didn’t come in at what they thought it would or what the Property Team had told them it would. Now, I’ve told and instructed all of our property teams, make sure you send people to a link so they can do their own research, a public rental site to find out what rents are, and give a range. Anyway, this lawsuit, they lost the claim against us, but it costs a lot of money just to defend ourselves, even though the judge ended up swearing at the plaintiff saying it was the most ridiculous case, but it still cost us a bunch of money to defend. What kind of policy could we have had in place that might have covered those costs?
Eric: That’s a tough one, because you basically need to have like a business liability policy. The extent that you’re running a business, you wouldn’t want claims against you committing or being alleged to being negligent.
Again, most insurance claims will not cover you against an intentional tort. If you’re accused of committing fraud, typically that won’t be covered by any insurance. They’ll defend you. They’ll pay for your defense, but they won’t pay for the claim, and a lot of cases, the defense is all you need. That would be more of a business policy, that you would get a typical policy protecting a landlord will not cover that, but if you’re in the business of doing this, you would want to talk to an insurance agent and say, “Look, I want to prevent these kinds of claims or at least to have insurance against it. What do you offer?” There are those types of policies, but they can be expensive. The main thing, in any transaction, is document and have it in writing exactly what you’re representing and what you’re not. The problem is, when people lose money or things don’t go well, they sometimes feel they have nothing to lose and it becomes a cost of doing business, and you have to factor that in.
Kathy: Well, it cost them over $100,000 just to lose the case, but I think they got poor legal advice, and the attorney probably told them they would get a bunch of money from us. There’s always attorneys out there that will make a lawsuit out of anything. That’s something that could have been easily resolved but I think they just got greedy and were hoping to get into our pockets. I think people can sue for any reason, and there is the cost to defend, so why not have insurance in place for those things, and the great thing about being a landlord is there are so many policies available for landlords.
Why Each Rental Property Should Have It’s Own LLC
Eric: Yet again, a secondary protection is, don’t be selling property or renting out property in your own name. Have it in an LLC. Also, if and when there’s a lawsuit, you have some protection that it won’t be against you. There are ways to get around that, attorneys will find, but the more layers of protection you have, the better. Rather than put five pieces of property in one LLC, you would want to have an LLC for every piece of property so that if you ever have a problem, the piece of property that has the issue is the only one that’s at risk and not whatever else you may have in your portfolio.
Kathy: Well, the frustrating thing about that is what you said earlier, the $800 per LLC California fee, but maybe there is a way around that.
Eric: Yes. If you look at the rules, what California did was, they basically say if you’re doing business in California, you have to pay an $800 fee, and they have an example in their forms that say, well, the example they use is someone that owns property in Nevada. In an LLC, they’re the managing member of the LLC and they live in California. Even though they have a property manager who handles everything, that because they’re the managing member of the LLC, and they do business there in California, that qualifies. They set a couple examples. They’re very aggressive trying to get as much money as they can, and they’ve lost in court a number of times. There are certain things you can try to get around that.
You don’t have the bank account in California. You don’t actually do any of the management while you’re in California. But imagine a rule that a company that has no contacts at all in California, but has an employee driving through the state that makes a phone call, does that somehow make them doing business in California? The state would probably take the position that yes, it is, but I think a judge would throw that out and say one phone call that’s made from the state should not count as doing business here. It is something to keep in mind, and the conservative approach is just pay the $800, but there are some ways if you limit what you do here to get around that because over 10 years that tends to add up.
Checkbook LLCs for Self-Directed IRAs
Kathy: Okay. Something you mentioned offline before the call was, some of these checkbook LLCs for your self-directed IRA, I see a lot of companies offering that. It’s always been a little concerning to me because there’s a lot to understand and make sure you do right, but what are your thoughts on the checkbook LLCs for self-directed IRAs?
Eric: The problem I see is that the companies that promote these, they make it look as if this is a completely settled area of law that you don’t have any risk, and we should backup this, and basically what these are marketed as, is you take your IRA funds, and you invest it in an LLC that then invests in real estate, and you become the manager of the LLC, and you basically manage the LLC yourself for your IRA. The rules regarding this are actually very– it’s very dangerous because you are not allowed– for example, let’s assume that you invested, you did everything properly, you had your IRA purchase an LLC interest, and you got a rental property and some repairs needed to be done. You went and did them. You painted a wall or you put in a new lock. The fact that you did that, you contributed a service under the IRS rules, render the entire IRA has being distributed, and you’d have to pay tax on your entire IRA.
There are certain things that the regulations will allow you to do, but as a general rule, and you can’t provide any services, you can’t pay any expenses. There has to be a total separation between the IRA investment and your contact with it. Let’s say you have an LLC bank account and you withdraw money and you use it personally, that can make your entire IRA now taxable. What you will hear from IRS auditors is, every single one of these self-directed IRA investments into like an LLC, it would be they could find something to make the whole thing taxable.
My concern is, at some point, as this becomes more and more popular, the IRS is going to start scrutinizing it because it could become a big source of revenue, and if that would happen, for the amount out there, it just could cost people an enormous amount of taxes. Just be very careful before you decide to do it. It can be a worthwhile investment, but look at the rules very, very carefully.
Kathy: Yes, it just makes no sense to me. It’s like you’re supposed to be arm’s length, and how can you be if it’s you writing the check, regardless of whether it’s an entity or not? Do you have any concerns with it being a self-directed IRA through a custodian?
Eric: Well, the more you have someone else doing it and not you, the better off you are. If you’re going to have an IRA, and you’re going to have someone else manage it, but again, it’s this whole conflict between control and liability. The more you have a third party involved, the more risk you have of being a victim of fraud or negligence, and the more control you have, the more you know what’s going on. I see both sides of it. I do think you can thread the needle. You just have to take the time, and before you jump in, you want to make sure you understand what all the rules are. There’s lots of literature out there, but don’t just take a promoter’s word of how easy something is. Make sure you research it. Worst case, have a consultation with a tax attorney like myself, where we see this all the time, we see what the audit risks are and an ounce of prevention, when it comes to tax laws, and especially with these IRAs where $100 mistake can cost you the entire value of your IRA, you just have to be careful. Life is risky. Generally, risk is rewarded, and you just have to be smart about it.
Kathy: Very good. Okay. Well, unfortunately, we’re out of time. I think I could just talk to you forever, but we’ll just have to have you back.
Eric: Well, thank you very much, Kathy, and congratulations. You’ve grown tremendously over these last years.
Kathy: 10 years. We met you 10 years ago. You helped us through some difficult times in the downturn. I’m glad. I think thanks to you, we were able to bounce back over the past 10 years, so thank you.
Eric: Well, it’s my pleasure. Thanks again, it was great talking to you.
Kathy: Thank you for joining me here on the Real Wealth Show.