There’s no doubt that landlords stay busy. They have to be investors, property managers, bookkeepers, service processors, lawn care and snow removal providers, just to name a few tasks. But what if you didn’t have to wear all these hats at the same time? You can keep these hats in different closets. By “closets” we mean legal entities. Generally speaking, there are two entities involved: the investment entity and the property management entity.
The investment entity’s sole purpose is holding real estate. The property management entity should handle day-to-day operations: property marketing, placing tenants, handling delinquencies, handling maintenance, caring for lawn and removing the snow.
This is obviously overkill for a landlord with only 1 property, since legal entities need to be set up and maintained together with accounting for each. But for a landlord who has 2+ properties there are clear benefits to creating a legal entity for property management (PM) and a legal entity to hold real estate:
First, this strategy offers a clear separation of investment income from ordinary income for tax purposes.
Imagine a situation where tenants break a glass window pane during move-in. The landlord fixes the window and invoices the tenant for the cost of replacing the window panes as well as his/her time fixing it. In this situation, the landlord wears a handyman hat, providing a service to the tenant. The income received for the service provided is not investment income, but ordinary income and needs to be taxed accordingly. When a landlord receives investment and ordinary income under one legal entity, it can be difficult to keep track of. Therefore, PM entity will capture all income received from providing the service to the tenant making a clear separation of investment income from ordinary income.
Creating different legal “closets” also offers more accurate net operating income representation.
When landlords wear their investor hats they closely watch their investment returns. The returns are calculated from net operating income (NOI). Landlords under a single legal entity tend to not include management costs, lawn care and snow removal costs. But, omission of these costs increases NOI, which increases investment return calculations.
What if the PM entity invoices the investment entity for management fees, lawn care cost and snow removal cost? The investment entity will pay the invoices and record them as maintenance expense. Now that the costs are accounted for, the NOI better reflects the operation of the investment, which in turn can provide more realistic investment return calculation for the investment entity.
This legal strategy also gives you the moral right to give the answer “Property manager” to the question—“Are you the owner of the property?”
Prospective tenants, city officials, cable installers, and others like to ask this question. Though there is nothing wrong with answering “Landlord,” the interested party assumes that since one is a landlord, they have authority to make decisions on the spot. When introducing yourself as a property manager working for a PM entity, the landlord doesn’t have to answer difficult questions on the spot and can reply “Let me check with the owners.”
There are many other benefits to separating the investment entity and property management entity. Hopefully, the benefits above give helpful reasons for landlords to start thinking about separating their roles into different entities. Or landlords can hire a professional property management company, like us.