Thinking of entering the business landscape of real estate investment? Learn to navigate it like a pro!
Maximize your rental property profits with these tried and tested financial best practices for both individuals and business entities.
Choose the appropriate business structure
The structure of the property you plan to hold and manage will determine the liability protection, insurance, lending, and taxes that will affect you going forward. Rental property business structures include sole proprietorship and the limited liability company model.
Sole proprietorship is simple but lacks liability protection and privacy. On the flip side, it’s easier to convert the property back into a personal residence if you plan to move in later. Landlords who keep rental properties under their personal name should have adequate landlord policy and liability insurance.
Alternatively, a Limited Liability Company (LLC) provides protection from personal liability and adds privacy. An LLC is a business entity that doesn’t pay taxes on corporate income, and the income passes through to the owners who report on their personal tax returns. An LLC impacts the cost and process for mortgage lending and landlord insurance due to its separate legal entity status.
Separate all aspects of your finances
To protect both your private funds and your rental property earnings, make sure to separate all finances, even if you directly own the property (as opposed to it being an LLC). Consider the three key aspects: bank accounts, cards, and bookkeeping.
You should have a general operating account and a separate account for each property’s security deposits. It’s important to keep security deposits separately to avoid accidental use of those funds.
You may choose to own multiple properties, like several apartment rentals in the same area, in one LLC with one operating account or to create a separate business structure for each property. Consider also keeping cash reserves in a separate savings account, linked to your operating account, to minimize the impact of unexpected events.
Using separate credit and debit cards for your business simplifies expense tracking and calculating profitability. It also helps maintain liability protection for those with an LLC.
Keeping organized books is essential for any rental property business, and using property management apps or accounting tools can help you with that. Spend time early on setting up proper accounting systems to make tax preparation season easier down the road.
Monitor your income and expenses
To manage your rental property effectively, it’s important to create a cashflow budget and update it regularly to compare it against actual expenses.
At the basic level, a good cash flow budget should include income sources such as rent and fees, as well as expenses like vacancies, mortgage, insurance, utilities, property taxes, maintenance, repairs, legal and tax costs, and more.
It’s important to estimate expenses accurately, and new landlords should consider adding an initial contingency of 5-10% to their projections. Use a tool like Excel/Google Sheets to keep all the data neatly organized.
This is another reason why separating your personal and rental finances is critical. It will help you follow the budget and correctly evaluate the impact of discretionary expenses on profitability.
Hire a professional tax advisor
A tax advisor with real estate expertise can make property management astronomically easier, especially to new landlords. Taxes can be complex and overwhelming, and your time may be better spent managing your properties.
A tax advisor can provide insights into the tax code and compliance that will benefit your business. Find a licensed tax professional who has a portfolio of serving many real estate investors, preferably someone who invests in real estate themselves.
A Certified Public Accountant (CPA) and an Enrolled Agent (EA) are two types of licensed tax professionals who can provide such services.
- A CPA is a financial expert who has passed a four-part exam given by the AICPA and is licensed by the state.
- An EA is a tax practitioner who has passed a three-part federal exam or has worked for more than five years in certain positions at the IRS, and is licensed by the federal government.
Figure out possible tax deductions
The IRS considers income from rental management to be passive income, which means that losses exceeding the income are not allowed in the ongoing taxable year but can be carried on into the next one. Unlike other small businesses, self-employment tax doesn’t apply to income from renting out real estate.
However, investors who manage rental properties so that they make a profit, as well as regularly work in their rental business should consider running it like an active venture. That way they might be entitled to the Qualified Business Income Deduction, which could bring them a tax deduction as high as 20% of their net income from rental property. This deduction is available through 2025.
To qualify, the taxpayer (sole proprietor or LLC) must keep individual records and have separate bookkeeping for each of their property ventures, provide at least 250 hours of rental services, and keep timely and contemporary records of those services.
When starting a rental property business, it’s important to choose the appropriate business structure and separate your finances. It’s also essential to create a cash flow budget and hire a professional tax advisor to help with code and possible tax deductions.
As a landlord, strive to protect your private funds, simplify expense tracking, and correctly evaluate the impact of discretionary expenses on your property’s profitability, ultimately leading to the success of your rental property business.