We provide here a few questions that have been posted in the Community Forums and our answers to them.

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Q1

My tenant is managing rental properties from my duplex where I occupy the other unit, resulting in the tenants visiting my property to pay their rents. Can I prohibit this activity?

A1

It may depend upon how much of an irritation this really is, your lease agreement, and/or other issues. Running a business in a residence can be prohibited by the lease for a rental home, by zoning laws, by business licensing requirements, by the landlord’s insurance, and/or by CC&Rs.

Whether the tenant receives compensation for management service or only manages his own rentals or does it for free as a favor to a relative or friend could be an issue. Managing one’s own rentals or doing it as a favor would usually not be prohibited by either zoning laws or CC&Rs. However, operating a property management business could be prohibited by either or both and/or by your lease agreement. In addition to possible zoning laws restrictions, most cities require a business license for operating any business, no matter where located.

Furthermore, managing real estate for compensation requires being licensed as a real estate broker in most, perhaps all states. Real estate brokers are also subject to other rules, including office location or signage in some states. You being aware of violation of licensing laws would probably provide leverage against the tenant for mutually agreeable early lease termination.

However, keep in mind that, even if the tenant is not doing something that is illegal or affected by any of the previously listed items, the landlord can increase the rent upon renewal or refuse to renew the lease. If month-to-month, he can raise the rent or terminate the tenancy with the minimum notice required by the law of your state (30 days in most states).

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Q2

My ex-tenants left damages costing about half of their security deposit to repair and did not provide a forwarding address. What do I do regarding returning what is due the tenants and an accounting of the unreturned amount?

A2

Send a check and the accounting to the address where the tenants lived at your property using one of the special addressing services called “ancillary service endorsements” that give the Postal Service specific instructions for how to handle the mail if it is undeliverable as addressed. Ancillary service endorsements include four basic phrases that are printed on the address side of your envelope:

    Address Service Requested

    Return Service Requested

    Change Service Requested

    Forwarding Service Requested

Undeliverable mail is handled differently depending on the class of mail, the endorsement you use, and how recently the addressee has moved. Some of these actions have fees associated with them. See the USPS Web site (http://usps.com) for details of the types of endorsements as they apply to different classes of mail and for the fees, if any, charged for the services.

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Q3

I am a rental property owner who has used a property manager to manage my property for some time, but now the property manager is requesting my Social Security Number in order to release the rent receipts paid to him by the tenant. At first the property manager’s reason was the new software needed my Social Security Number. Now the reason is the rent receipts cannot be issued without my Social Security Number. Is this legal? My Social Security Number is sensitive personal information. Is there a legal basic for requesting my Social Security Number? Please comment.

A3

Either or both reasons given could be entirely legitimate. The new software used by the property manager (PM) may indeed need the SSN information in order to print even if the old software didn’t. Many such programs cannot print until all data fields have info in them. Furthermore, although often ignored by PMs, a PM is required by law to file 1099s with the IRS and with state taxing authorities showing the gross rents collected on your behalf if they total more than $600. Failure to provide 1099s regarding collected rents can be very costly to the PM if caught.

This is almost certainly the reason for the software requirement. Accordingly, using a phony SSN to make the software print is not a solution. The fact that the software needs your SSN should not mean that your SSN is provided to the tenants and it wouldn’t hurt to get a guarantee of this from the PM. However, some states have rental related income tax credits for tenants and the law requires that the tenant be provided a taxpayer ID of some kind associated with the landlord in order to claim the credit.

Your SSN was probably not needed in the past because the PM was not obeying one or more laws and he was using software that did not force him to do so.

This should not be an issue for owners who are holding title to rental properties in the name of a limited liability entity such as a LLC. All real estate investors should absolutely be doing this, with a separate LLC for each individual property. Each such entity can and should obtain an Employer Identification Number (EIN) and that is what should be provided to the PM, governments, tenants, and anyone else requiring such information. Doing this avoids the need to provide a social security number to anyone for any reason related to the rental properties other than to a lender if/when financing or refinancing a property.

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Additional Information

Most of the issues discussed in these Q&A’s are covered in considerably more detail in our eCourses and/or in our Mini Training Guides.

We provide here a few questions that have been posted in the Community Forums and our answers to them.

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Q1                                                         

I received a deposit to hold a unit for a new tenant. The tenant then called a few days before scheduled move-in date to tell me he had changed his mind and wanted his deposit back. What are my rights.

A1

That might depend on details not provided in your posting. Although you call the person a tenant, you do not explicitly state that the lease has been fully executed. Also, you are not specific regarding whether the deposit was a security deposit under terms of the lease or was actually a separate “holding deposit” for which there should have some other written agreement.

If you and the person executed a written lease agreement, you can hold him to the terms of the lease. However, if the person chooses to break the lease, you can only hold him responsible for the rent until a new tenant begins paying rent and you must exert reasonable effort toward finding a new tenant. You can probably also hold the person responsible for paying extra expenses related to again having to market the property, including advertising and leasing commissions.

If it is an oral lease and there is no written lease agreement, it would be your word against his as to the exact terms of said agreement unless there were witnesses on one or both sides.

If the deposit was a holding deposit you must abide by the terms of the holding deposit agreement. Again, if there was no such written agreement, it could be difficult to prove the terms of the deal.

For additional discussion of the issues, please provide more details related to the issues mentioned above.

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Q2

I bought a 4-plex three years ago. It operated from the get-go with a significant negative cash flow that was not a problem until last month when I lost my job. Any ideas what I can do to avoid foreclosure? What are the ramifications of being foreclosed?

A2

Unfortunately, there may not be a simple solution. Unless you put a substantial amount down on the property, unlikely considering that you have a significant negative cash flow, you won’t be able to refinance at a lower interest rate even if you still had your job because it would not likely appraise high enough in today’s economy and you might not now qualify for a loan with tougher qualifying criteria than existed a few years ago.

There are many ramifications from suffering a foreclosure. In addition to long-term damage to your credit rating, you may have to pay federal and state income tax on the amount of the loan that is “forgiven” upon foreclosure which the government usually considers to be income. Depending on both the size of the loan and your marginal tax bracket in the year of foreclosure, the tax could be substantial. The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence only and does not apply to rentals.

Of further concern is that, unless you live in one of the few states that have anti-deficiency statutes that might apply to this type of  property, if the lender sells the property for less than the loan amount (plus late charges, attorney fees, and other costs) you may be sued for the amount of the lender’s loss.

Your best bet is to find new employment in order to avoid foreclosure and to do so as soon as possible in order to minimize damage to your credit rating and the other potential problems. Another possibility is to see if the lender is willing to reduce the monthly payments, but this would itself be easier if you are employed.

Yet another idea is to see if you can find one or more relatives and/or friends interested in becoming a partner, with the investor(s) putting in capital as needed to keep the property afloat and his share of the property depending on the amount of capital contributed. You do, however, have to be careful not to trigger any alienation clause in your note by transferring an interest without the lender’s permission. I would expect that the lender might be willing to allow you to take on a partner since most lenders currently have more than enough owned properties from foreclosures and will not likely want to own your property if it can be avoided.

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Q3

I have a 27 unit building with a common lobby entrance. A few weeks ago, on a Saturday when the manager was away from the property for much of the day, a tenant’s key became stuck in the lock on that entrance door, apparently rendering the lock inoperative. The tenant removed the lock, but was still unable to remove his key. The tenant then left the lock out because no one would have been able to gain access unless the door was left propped open. Upon return, the manager had a locksmith make a Sunday service call to deal with the problem and he installed a new lock. I sent the tenant a bill for the $258 service call because it was my opinion that my handyman could have repaired the old lock on Monday if given the chance to do so. The tenant claims that inadequate maintenance was the cause of the problem, making it my problem.

A3

Based on my understanding of the matter, there are at least a couple of reasons why the tenant should not be considered liable for the locksmith bill.

First, I think that your manager did the right thing by immediately calling for the locksmith when she was not able to herself fix the lock. Not having a lockable entry door for a couple of days/nights would have left you exposed to serious liability had it resulted in theft of a tenant’s property or injury to a tenant by someone who would not normally have had access to the building.

Second, it was probably not the tenant’s fault that his key could not be removed from the lock. It is likely that the problem was indeed due to the lock being old and worn or not having adequate preventive maintenance. The fact that it cost $258 rather than a few dollars for regular maintenance or less than a hundred dollars for your handyman to have replaced the lock at an earlier date was not the tenant’s fault. I think it likely that a judge would look at it the same way

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Additional Information

Most of the issues discussed in these Q&A’s are covered in considerably more detail in our eCourses and/or in our Mini Training Guides.

Just Say No

In filling vacancies, there are times when the best business decision you can make is to say NO. Saying “no” can be a difficult decision for some landlords either because they desperately need to fill the vacancy or they get caught in the emotion of the applicant’s situation.

There are also those landlords who believe they cannot say no without risking a violation of fair housing laws. While it is true that fair housing laws offer protection to certain classes of individuals, it is not true that you cannot legally discriminate.

As the landlord, you should set your rental policies based on sound business criteria. Those business criteria, if developed and implemented correctly, give you the right to say no to unqualified applicants.

The key is to understand that filling vacancies is a business decision. The decision you make will either make you money or cost you money. Is this applicant worth the risk? You need to make sure your no is reasonable and justifiable. If you say no to everyone you won’t be able to fill your vacancy, whereas, if you say yes with even the slightest doubt, you need to be sure you can accept the risk.

Screening is a way to evaluate the degree of risk that the applicant represents. Too often we think that screening only starts with ordering a credit report. However, with the first response to your marketing efforts, you make the first decision, yes or no. The caller asks if pets are allowed. Your rental policy says no. The open house visitor has a rent budget of $500. Your unit at fair market rent is $650. You say no. The applicant hands you an application that is obviously incomplete. Should you accept it? The business decision should say no.

What are the reasons you can legally reject an applicant? It is usually not illegal to reject an applicant under the following circumstances:

Personal Identification – If the applicant cannot furnish proof of his identity, do not accept his application. It is reasonable to require that an applicant furnish at least two forms of personal identification, with one being a current photo identification document.

Social Security Number – While it may be possible to conduct various tenant screenings without the applicant’s Social Security number, do not make exceptions. Require that all applicants furnish a Social Security number or other taxpayer identification number in order to run applicable screenings.

Refusal to Sign Application or Consent – While unlikely that an individual applying for housing will refuse to sign the application, it can happen. If the individual signs the application, but refuses to sign the consent for screening, you probably can conduct screenings, but why take the risk that later the applicant/tenant contests your right to gather information. If the applicant refuses permission for screening, you should say no.

False or Misleading Information – Your rental policies should contain a statement that any false information given or discovered during the course of application and screening would be grounds for rejection of the application. If you determine that the applicant has provided false or misleading information on his application or through his references you should say no.

Cannot Meet Deposit Requirements – If the applicant’s income is apparently sufficient, but he requests an accommodation of the deposit amount or a deferred deposit payment schedule, you may want to rethink this applicant. If you say yes to this, be very sure it is a business decision and not a preferential or discriminatory reason. The best decision is to say no if the deposit amounts cannot be made before lease signing.

Is Not of Legal Age – You cannot have a valid lease agreement if your applicant is not of legal age or considered an emancipated minor according to your state’s law.

Exceeding Occupancy Limits – If there is a valid reason to limit occupancy, such as for health and safety reasons or due to limitations of the unit’s mechanical systems, you can say no. However, be careful that your occupancy limit can be supported.

No Employment – You want the applicant to be able to meet rent payments. Without employment or some other verifiable source of income, there is no reason to assume the applicant can make the rent.

Insufficient Income – You want a tenant who has enough income to pay the rent and his other living expenses.

Cannot Meet Terms of Lease – Your rental policies state your lease terms and conditions. You should also re-state them when you accept an application. If the applicant requests negotiation of certain terms, or cannot meet the lease terms, think again of the risk and claims of possible discrimination if you alter such terms.

Insufficient Rental History – Are you willing to accept first time renters, students and others with a limited history, or former homeowners now re-entering the market? If they don’t meet the requirements of your policies, say no.

Guarantor or Co-signer – A co-signer or other conditional acceptance requires more time, effort and money to process and monitor throughout the tenancy. Do you really want to offer this option? Once the policy is set, stick to it.

Bad Landlord References – Did the applicant gave sufficient notice before moving and generally adhere to the terms of the lease? Would they rent to this individual again? Rent payment history, property damage, and whether full deposit was returned provide clues for future rental performance. If the landlord who knew your applicant doesn’t give a positive endorsement, you should say no.

Bad Employment References – If possible, ask the supervisor if the applicant is considered a good employee. Is there a history of tardiness? Behaviors at the work place can also be indicative of actions taken outside of work.

Bad Credit History – Credit management history is clearly shown in credit reports. With a history of late payments, missed payments, or debt obligations that burden the ability of the applicant to meet current or future debt, you should say no. You should say no if public records indicate the individual has uncollected items, liens, judgments.

Credit Score – While there is no magic number, there is indeed a range that indicates potential trouble. Become familiar with credit scoring models and set your rental policies so that the minimum acceptable score is consistent with the location and condition of your property.

Evictions – Most landlords do not want a tenant who has been evicted. Some landlords think of this condition as a make or break deciding factor. Other landlords place less of an emphasis on evictions if the eviction occurred in the distant past.

Bankruptcy – You have the right to say no to an applicant who has filed bankruptcy. However remember that once discharged, applicants cannot file again for a certain number of years, the number depending on the chapter filed. Past problems may have taught the applicant a valuable lesson.

Criminal Record – A criminal conviction can be reason to say no if the nature of the crime presents a future threat to the safety of others or damage to property. Ex-convicts are not a protected class with one exception – individuals with convictions for past drug use. Past drug addiction is considered a disability under fair housing laws. Individuals with convictions for sale or manufacture of drugs or who currently use illegal substances are not protected under fair housing laws.

Sex Offender – Megan’s Law requires persons convicted of violent sexual offenses and sexual offenses against children to register with law enforcement officials in the state where the person lives. While most states have online databases where such information can be searched by the general public, you should be aware that in some states there are restrictions on whether this information can be used to deny rental housing. If your state’s law does not prohibit such actions and you are reasonably certain that the person poses a current, direct threat to your other tenants, you can say no. You may also wish to consult a competent attorney regarding the matter.

Pets – If your rental policy is “no pets,” then you can say no to an applicant who also wants his dog to move in. However, be aware that in the case of service animals you must accommodate the tenant’s request.

Smoking – Since smokers are not a protected class, you may prohibit smoking in your unit or on your property.

Has Water-Filled Furniture – If your rental policies say no water-beds, then say no to applicants who have one.

Has Home-Based Business – Many individuals are self-employed and do work from home. Be sure you know your local regulations regarding zoning, know any HOA restrictions, and understand related insurance issues before saying yes.

As a final note, do not assume you can legally discriminate for any reason that is not mentioned by name in federal, state, or local fair housing laws. Courts in some states have ruled that discrimination on the basis of personal characteristics constitutes arbitrary discrimination and is illegal. You may think you can say no to an applicant because of his occupation (e.g. attorney). If the applicant was otherwise qualified, you could find yourself defending a fair housing claim based on your arbitrary decision not to rent to attorneys. Be very thorough in your evaluation of applicants and base any decision on facts that can be supported based on business principles.

If there is a business reason to say no, you can legally say no. However do not use a business excuse to disguise illegal discrimination.

Single-Member LLC Risk

With every state having adopted the LLC as a limited liability business entity over the past couple of decades, the LLC has become the entity of choice not only for operating a business but also for ownership of real estate. However, although once considered a nearly bullet proof shield against lawsuit judgments reaching personal assets of business and real property owners, LLCs, particularly single-member LLCs, are coming under attack in courts around the country.

The primary advantage of an LLC is that owners are not personally liable for claims against the LLC, whereas, for sole proprietorships and partnerships all personal assets of a proprietor or general partners are at risk when a claim is made against the business. For a rental property owned by individuals or by a partnership (either general or limited types), a substantial judgment obtained by a tenant of one property can potentially result in loss of that particular property, all other real property, and all other assets of individual owners or general partners.

However, when each property is owned by a separate LLC, a judgment in favor of a tenant of one property may result in loss of that property but the tenant cannot attack the personal assets such as homes, bank and brokerage accounts, or other rental properties or businesses held by other LLCs.

Of further benefit is the fact that the statutes of most states do not allow a judgment creditor to obtain any ownership or operational control over a LLC. The creditor only obtains a “charging order” against the interests of the member. A charging order is a court order granting the creditor the right to garnish distribution from the LLC to the member. Accordingly, a member who does not depend on cash flow from the LLC can indefinitely delay distributions. This can force the creditor to agree to a settlement acceptable to the member.

Charging orders were carried over to LLCs from partnership law where they originated for the purpose of preventing the interest of other partners being jeopardized by a judgment against one partner. However, in recent years some courts in the country have taken the position that for a single-member LLC there are no partners to protect and single-member LLCs have lost some protection.

Example 1 (Littriello v. United States) – Frank Littriello was the sole owner of several Kentucky limited LLCs that did not make elections on Forms 8832 to be treated as corporations, and therefore were treated as disregarded entities by the IRS, pursuant to the default classifications under Treasury Regulations. The IRS assessed employment taxes on the LLCs, which flowed up to Littriello as the sole owner of the disregarded entities. The IRS won this one when the Sixth Circuit Court in 2007 affirmed the WD Kentucky District Court’s 2005 holding.

Example 2 (Olmstead v. Federal Trade Commission) – More recently (June 2010), the Florida Supreme Court issued a ruling for a $10 million judgment against Shawn and Judy Olmstead, allowing their creditors access to all their assets held in single-member LLCs.

Note that this case might have been decided differently in a different state. Some states allow foreclosure of an LLC interest, others provide that a charging order is the exclusive remedy of a creditor, and yet others are silent on the issue. The court reasoned that because the Florida LLC charging order statute does not expressly provide that a charging order is the exclusive remedy (general and limited partnership statutes do provide so), the LLC charging order is not the exclusive remedy and, thus, a creditor may levy on the LLC interest.

There are some ways to protect single-member LLC assets.

• Don’t commit negligence, fraud, or illegal acts – this will avoid liabilities whether or not the assets are protected.
• Follow the first advice item as well as possible, maintain high ethical standards, show respect and kindness to all, avoid careless decision making, and don’t be greedy.
• Understand the LLC statutes of your specific state.
• Form and operate your LLCs legally and in accordance with the operating agreements.
• Add another member to any single-member LLCs.
• Obtain business liability insurance and an umbrella policy having limits as high as possible.

An LLC is the only business structure that can choose how it wants to be taxed. However, the LLC must make a choice by filing the appropriate election with the IRS (Form 8831) unless the default entity is the entity of choice. Otherwise, the IRS will automatically assign a default tax status, based on the number of owners – a partnership if two or more owners or “single-member disregarded” status if only one owner (member). The latter can mean that the LLC is no different from a sole proprietorship as far as the IRS is concerned.

While, for an operating business the problem can be avoided by operating as either an S Corporation or C Corporation, with one of these actually often being tax-wise advantageous for an “active” business, an LLC taxed as a partnership is usually tax-wise preferable for the “passive” business of owning rental properties.

In order to maximize the protection provided by LLCs, there are other things that must be kept in mind no matter how many members. It is very important that individual LLCs be operated as separate independent entities, separate from one another and separate from the owner. Important issues include the following:

• Follow the operating agreement regarding any required meetings and other formalities and be sure to generate related documentation.
• Maintain separate LLC checking and other bank accounts rather than use your personal accounts for the property, preferably separate accounts for each LLC.
• Avoid commingling of personal assets with LLC assets and commingling of one LLC’s assets with another LLC’s. Do not write checks between LLCs unless as formal documented loans. Never pay for personal expenses from a LLC checking account.
• Maintain adequate reserve funds within each LLC to minimize the risk of commingling.
• Maintain utility, vendor, and other accounts in the name of the individual LLCs.
• File a fictitious name statement if you want to do business under a name other than that of the LLC.
• Always properly document any changes in ownership or management of the LLC.
• Use LLC-specific letterheads, envelopes, tenant notices, etc.
• File LLC tax returns.
• Execute documents on behalf of the LLC rather than as an individual.

LLCs still provide the best asset protection for most real estate investors. However, you should stay alert for future changes in LLC law and tax law, including law arising from statutes, regulations, and court decisions.

Additional Information

For additional discussions regarding LLCs in considerably more detail than is provided by this series see our “Buying Income Property” and “Managing Income Property eCourses.