Deciding If Refinancing Is Beneficial – Part 3

In Part 1 of this series we covered some basic issues regarding the decision of whether or not to refinance a property. In Part 2 we considered the basic principles related to determining how long it takes for the reduced interest rate to repay the costs of refinancing. We ended Part 2 by mentioning that when analyzing the benefit of a lower rate loan must consider the after-tax numbers rather than only the amount of interest included in your payment. To varying degrees, other loan costs must also be analyzed for tax affects.

In fact, you must consider that if not regularly in the zero marginal tax bracket you may even pay more income tax after refinancing at a lower rate, at least in some years. In review, the marginal tax bracket is the percentage of taxable income you will pay if you have more in income or less in deductions than expected. The marginal federal tax rates in 2013 ranged from 0 percent for taxable income of less than $18,150 to a maximum 39.6 percent for taxable income higher than $457,600. For examples in this article we’ll assume a marginal federal tax rate of 25 percent with taxable income between $73,800 and $148,850. State income tax rates vary from zero for states having no income tax to around 9 percent in states having the highest maximum rates. Municipal income tax rates for those cities taxing income vary from a fraction of a percent to around 3 percent in some of the higher rate cities. Although landlords often have lower taxable income than the typical taxpayer because of depreciation, for the examples in this article we’ll assume a total (federal + state + local income taxes) marginal rate of 30 percent.

Refinancing can result in a higher income tax because you are paying less annual interest on the new loan than you were paying on the old loan, resulting in a smaller expense deduction. The impact of this fact depends on many variables including the difference in interest rates between the old and new loan, whether or not the old and new loans had equal amortization lengths, the percentage of the amortization term that has passed since the old loan began, and, and of course, your marginal tax rate. Accordingly, the after-tax interest savings is reduced by the tax on the interest savings on the new loan at its beginning compared to the interest on the old loan at the time of refinancing. While refinancing is usually beneficial in the long term, it is entirely possible to have little benefit in the short term taking into consideration the time spent on obtaining the new loan, even experiencing a net loss in the early years after refinancing.

As an example, we’ll assume that you are refinancing a loan that has a current balance of $200,000 and, due to the current financing market conditions, rates have dropped in the interim resulting in a new rate for a fixed rate 30-year long that is 2.0 percent lower than the rate of the old loan. We’ll also assume that the old higher rate 30-year loan was obtained relatively few years before, meaning that the amount of principal pay-down is small relative to the size of the loan, and we will be refinancing approximately the amount of the old loan principal balance. Also, although the refinance could have been done at any time during the tax year, meaning that the interest savings for the year of refinance might be less than a full year’s amount, for simplicity we’ll assume that the loan closed at the very beginning of the year resulting in a full year of interest savings.

These assumptions provide an interest savings of approximately $4,000 in the first year, ignoring that the amount of interest drops a little for each monthly payment. This translates into an additional $1,200 in income tax, leaving $2,800 of the first year interest savings to apply against the refinance costs.

Now, one might expect that we will receive a significant income tax savings in the first year from deducting the refinance costs. However, the tax code reduces the benefit because some of the costs that you pay up-front to refinance are not fully deductible on your first year’s income tax return, but must be amortized over the life of the 30-year loan. Escrow fees, appraisal fees, and title insurance premiums are in this category, as are certain other types of loan related costs. This means that, although your reduction in interest costs are essentially taxed fully as the benefit is received, you can only expense 1/30th of many refinance costs each year even though you paid them all at the closing of your new loan. There could also be costs that are not related to the loan term and must be spread over the depreciation life of the property – 27.5 years for residential property or 39 years for commercial. An example of this last issue would be if the lender required correction of some deferred maintenance, with the cost likely being deductible, but only as additional depreciation.

Continuing with our example, we’ll assume that you’re paying a 2 points loan fee, not an unusual fee for rental properties. We’ll further assume that the total fee is fully deductible because of what it’s called by the lender and it meets the then-current IRS rules, not always the case. This should result in a deductible amount for loan points of $4,000 (2 percent of $200,000). We’ll assume that all other costs of refinancing – including appraisal, lender title insurance, and escrow fee – totaling $3,000 must be amortized over 30 years ($100 per year). So, ignoring the value of the time spent for refinancing, you have a total refinancing cost of $7,000.

Thus, from the refinance costs, we have a tax deduction of $4,100 ($4,000+$100) for the year of refinancing, but a deduction of only $100 for each year thereafter. With the net interest saving from being in our 30 percent tax bracket, the first year deduction of refinancing costs results in a tax savings of $1,230 (0.3X$4,100). Thus, the total amount of interest that can be applied against the costs of refinancing for the first year is $2,870 ($4,100-$1,230), leaving a balance of $4,130 ($7,000 – $2,870) to be recovered in subsequent years.

For the second and subsequent calendar years, ignoring the changes in interest as the loan amortizes – reasonable for the first years of the new loan – we’ll have $100 being deductible from refinance costs, producing a tax savings of $30. Adding this to the $2,280 net (after-tax) savings from our lower interest rate gives an amount of $2,310 to apply against the costs of refinancing in subsequent years. Thus, applying that amount against the $4,130 balance of refinancing costs remaining after the second year leaves $1,820 ($4,130-$2,310) to be paid off in the third year. It would require approximately 8 months of the third year to pay the balance.

For our example, it required approximately 2-2/3 years for the savings to pay the costs of refinancing. How long it requires for your refinancing will depend on all the variables for which we made assumptions in our example and on others possible variables not considered. The time required could be somewhat shorter or significantly longer, depending on the numbers. Note that refinancing at other than the beginning of the year, as we assumed, would not have changed the fact that approximately 32 months would be required. Of course, depending on the month when the new loan replaced the old one, it might require spreading our recapture of costs over 4 tax years rather the 3 for our example where we assumed the refinance occurred at the beginning of the year.

For the case of your marginal tax bracket being zero, the time for recapture of financing costs is simply the costs divided by the interest savings – $7,000 divided by $4,000, or 1-3/4 years. At the other extreme of the highest possible marginal tax bracket, the time for recapture of financing costs would be greater than for the 30 percent bracket of our example. As expected, taxation has ramifications for the refinance issue, just as it does with all other aspects of life.

An analysis that provides accurate results becomes significantly more complex when the loan being refinanced is older, the difference in interest rates is smaller, amortization periods are different, one or both old and new loans have variable interest rates, the borrower has marginal tax rates that change year-to-year, and other factors.

In Part 4 of this series we will look at some other issues regarding refinancing that can further complicate making the decision of whether or not to refinance.

Question

I bought a rental home about 4 months ago that had existing tenants. I was told by the seller that the tenant had no security deposit. The tenant’s lease term expired and the tenant vacated the house last week. The tenant now claims to have a $760 security deposit that he wants returned. Who is responsible?

Answer

You need to first determine who is telling the truth. Did you not obtain a copy of the lease agreement prior to buying the property that confirmed what the seller told you? The original should have been turned over to you upon close of escrow, but a copy should be sufficient. Additionally, even when copies of lease agreements are provided by the seller, one should NEVER buy a property occupied by tenants without requiring that each tenant execute an Estoppel Certificate.

If you have a lease agreement copy confirming that there was no deposit, ask the tenant to provide a copy or an addendum or amendment showing something different. If there is a discrepancy, you will need to resolve it by comparing dates of execution and signatures between the documents. If there is only the tenant’s version, you may have to go by that unless the seller is willing to testify differently.

Although it is my understanding from your question that there is a written lease agreement, if there is no written lease agreement, it could be a bigger problem because it will be the word of the tenant against the word of the seller even if the seller testifies.

By law in most, perhaps all states, the current owner is responsible for the deposit even if not given credit for the amount at close of escrow. If there is in fact a deposit you will have to fund any part of it being returned. It would then be up to you to attempt to now collect the entire deposit amount from the seller. Your promise to press a claim of criminal fraud if he refuses to pay might be helpful in collecting without filing a lawsuit, but be certain you have irrefutable proof that he lied before doing so.

Be sure to return the deposit and/or an accounting for any portion not being returned to the tenant within the time required by your state’s law.

Unless adequate documentation was used by the seller, including a detailed move-in checklist that was provided to you by the seller, there will be additional problems if you try to deduct from the deposit any amounts for damages that occurred prior to your documentation of the condition of the property during an inspection following close of escrow.

Question

I recently discovered that the tenant to whom I had rented a house a couple of months ago failed to switch the electric account which was in my name over to her name. The account has now been switched into her name, but the tenant is refusing to reimburse me for the payments I made to avoid damage to my credit. She has even hinted that she may not pay future bills. What rights do I have? Can I charge late fees or interest? Would this be an adequate issue for eviction?

Answer

What you can do depends almost entirely on the adequacy of your lease agreement regarding the matter. If the lease required the tenant to immediately switch the electric upon signing the lease, you can sue her for the amount owed via a lawsuit in small claims court after providing a written demand for payment if you have not yet done so. You could instead give written notice to the tenant that she is in default of the lease and that she must correct it or leave. You must provide the notice in accordance with the law of your state regarding this type of notice, how it must be served, and the number of days that must be allowed for correction of the default. You want to be able to sue for these costs if she “quits.” If not paid within the required notice period you can start an eviction.

If the lease does not cover the matter or does not do so adequately, you could have trouble collecting. This would be particularly true if the lease did not even specifically make her responsible for paying for electricity, as she could take the position that electricity was included and it would be her word against yours.

Some states allow providers of certain utility services to collect from the owner if a tenant does not pay the bills, even lien the property and/or refuse service for you or a successor tenant if the current tenant’s bill is unpaid. This is most often related to the fact that a utility is operated by the city, most common for water service. You need to check the law of your state and the policy of the electrical service providing for your property to see if this is another issue for you.

In addition to being sure that the lease agreement is adequate regarding the subject, one should not give possession while any utility that is to be the responsibility of the tenant is still in the landlord’s name. In many states landlords cannot legally have utilities turned off once the tenant is in possession. Of course, one cannot turn off any utility related to heating a unit if located in a climate where water lines might freeze and one may have no choice about leaving the utility on. This issue is best dealt with by requiring the tenant to prove the utility has been transferred prior to giving possession.

Question

I am considering the only application I have received for my vacant rental home. The person is fairly well qualified under all my screening procedures, but is short regarding the total amount of cash he will need including rent, security deposit, utilities services, and his moving expenses. The applicant is a carpenter employed on some construction in the area. He has asked to be allowed to cover the amount of the security deposit by doing some work that I need done on the property. Are there any problems with doing this?

Answer

First, any such agreement should be in writing. If it’s not in writing, the terms of the agreement will depend on who the judge believes and that may be the party who is the best liar. The terms of the deal must be covered in detail. The contract should include the exact tasks to be performed and the scheduling of the work, particularly the completion date of all work.

Second, allowing a tenant to do work for money (including credit against deposits or rent) can subject the landlord to employment issues such as workers’ compensation insurance, FICA tax, FUTA, and income tax withholding. It can also expose the landlord to liabilities resulting from injury to the tenant or to others by the tenant while working on your property. Landlords must be sure of their insurance coverages regarding such issues. While one may assume that tax and workers’ compensation issues can be ignored by considering the worker to be an independent contractor, such is often not so. There are IRS and other federal and state laws/regulations that determine whether a worker is an employee or and independent contractor. The details of these rules are beyond the scope of my answer, but info is easily found on the Web sites of the IRS and other relevant agencies. I will mention that you will have significantly less risk if the worker is a licensed contractor who meets the appropriate criteria, the most important perhaps being that you specify the results and he controls the process for producing the results.

Third, the fact that a tenant works to pay the security deposit does not change the fact that the deposit (money earned) belongs to the tenant unless and until converted to landlord’s funds because of unpaid rent, damages, etc. You will have the same requirement of returning and/or accounting for amounts not returned on the same schedule as required by law if the tenant had paid cash in the beginning. Failure to do so can subject the landlord to any penalties provided for in the state’s landlord-tenant law.

Finally, if you decide to go ahead with this tenant, I would advise that he be required to pay the security deposit up front and work off the first month’s rent. The reason for this is that it is usually easier to evict a tenant for non-payment of rent than for most other reasons. It also changes the risks related to security deposit laws.

While I have discussed important issues related to your question, I would strongly advise against having tenants do work on your property, as there are other potential problems. For example, would his failure to provide completed results up to your standards allow you to obtain an eviction?

Question 1

Can you tell me which method of rental marketing is usually the most effective? Even minimal classified advertising in the newspapers has increased greatly in recent years.

Answer 1

The best way to find prospects and the lowest cost way is usually to use “For Rent” signs on the property in locations that are visible to people driving or walking by the property. The fast way to get a prospect that has viewed the property to sign a lease is to offer good value. This includes providing clean, well-maintained, and safe units at or below market rent for the area. This can also give you a better chance to get “good” tenants because those who are financially qualified and have a good rental history do not usually need to live in bad rentals.

However, it is best to concurrently utilize multiple methods such as placing classified ads in local newspapers, posting notices in local public bulletin boards (e.g., those often found in neighborhood markets, laundromats, and other venues), and listing vacancies on rental Web sites.

There is a way to minimize the cost of all advertising methods that are charged by the lines or by the words as well as provide interested persons with a lot more detailed information than is otherwise possible. This is to provide your own Website which provides information on each of your properties and in your paid advertising provide the page Web address that provides details of the vacancy or vacancies being advertised. The Web address should be included on your signs in addition to the phone number, even instead of the phone number, as that will be available on the Web site which will be accessible to most interested persons via their smart phones.

The site can include information regarding qualifying criteria, pet policy, the rules and regulations of any HOA, utilities paid by landlord if any, and how much. Of course, the site can exhibit an essentially unlimited number of photos. Finally, the site can also provide downloadable application forms, a copy of the lease agreement that will be used, and other lease documentation, for example your pet agreement if not contained within the lease agreement.

The annual cost of registering a domain name and paying for its hosting is quite low and your site can provide everything a potential applicant might need to know in order to decide if your rental is a serious prospect for his/her housing.  Accordingly, you will be answering fewer inquiries from those who are financially unqualified or for those you will have no interest in after they know the details.

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Question 2

We signed a lease agreement with a new tenant yesterday that is to begin in a week. However, we now think that we made a bad decision. We have heard that our state has a law that allows cancelation of home improvement contract without penalty within a certain number of days after signing and wondered if there is a certain period after signing when either party can cancel the lease. We have not deposited any money and want to tell the prospective tenant that we will not be able to go through with the lease agreement and void her check.

Answer 2

You don’t say which state the rental is located in, but to my knowledge no jurisdiction in the country has a law that allows either a landlord or a tenant to change his mind after a lease is executed by both parties. An exception would be if it could be shown that one or the other parties committed fraud. Some states have laws regarding rescission of a contract within a few days for some types of contracts (e.g., a home improvement contract), however, any consumer protection law that allows cancellation of a contract almost certainly applies to the rights of the consumer, not the merchant, again, except when the consumer committed fraud against the merchant (e.g., providing incorrect information on the application that is material to the landlord’s selection decision).

Landlords should never make “rent”/”not rent” decisions based on gut feelings. Decisions should always be made based on the results of an adequate number of objective screening procedures, including identity verification and credit reports as a bare bones minimum. If possible, screening should also include verification of employment, eviction record checks, contacts with previous landlord(s), and criminal record checks. If you made the decision to rent to the tenant after you performed such screening I don’t understand why you would now have a concern.

You don’t say anything about the length of the lease. If a month-to-month lease you could immediately give a termination notice (30-days-notice in most states) and you would likely find that the tenant would prefer to cancel the lease rather than again move within a month. Whatever the length of the lease, you could still inform them that you will not be renewing the lease in hope that the tenant would agree to cancel.

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Question 3

I own a rental home for which the tenant is about half-way through a one year lease. My sale of the property to an investor is scheduled to close escrow in 2 weeks. A few days ago I notified the tenant of the pending sale, informing her of the name of the buyer and the address where he wishes future rent checks mailed.

Today I received a “Notice to Terminate Lease in 30 days” in the mail which included a note stating that she is terminating her lease because the rental agreement does not address a transfer of ownership and therefore she has the right to break the lease. I passed this information on to the buyer and he says that he will need an adjustment in sale price because of the fact that there will be an unexpected vacancy.

What are my options?

Answer 3

You actually need no options. Change of ownership does not affect a lease agreement in any way unless stated otherwise in the document. The tenant cannot use the sale as an excuse to break the lease or to avoid adhering to all terms of the lease agreement. You should immediately inform her of this fact and warn her that breaking the lease may result in significant financial cost to her in addition to the expense of moving.

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Exchanging Vacation Homes

Most real estate investors are aware that Section 1031 of the Internal Revenue Service Code provides for tax deferred exchanges of real property held for investment. Section 1031 of the IRS code currently provides that

“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or a business or for investment.”

The basic rule is that the relinquished (old) properties and the replacement (new) properties must be of “like kind,” with “like kind” being defined very broadly. A duplex can be exchanged for vacant land and a shopping center can be exchanged for oil wells or timber land.

Furthermore, property held for productive use in a trade or business may be exchanged for property held for investment, and property held for investment may be exchanged for property held for productive use in a trade or business.

Another basic rule is that “you can’t touch the money between the sale of your old property and the purchase of your new property.” Any funds or other items of value received, even temporarily, by the exchanger become “boot” and are subject to taxation. Accordingly, the IRS Code requires that an independent third party, called a Qualified Intermediary (QI), be involved in handling the transaction except in the very limited case of a simultaneous exchange.

Rules, upheld by court decisions, specify that gain or loss from an exchange of personal residences may not be deferred under Section1031 because the residences are not property held for productive use in a trade or business or for investment. The Tax Court has held that a personal residence property is held for personal use and that the “mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence.”

In spite of the Tax Court decision, the Service recognizes that many taxpayers hold dwelling units primarily for the production of current rental income, but also use the properties occasionally for personal purposes. This property is often called a vacation home.

The IRS Code lays out in detail the procedures for turning a sale and purchase type transaction into an exchange. This article briefly discusses the narrow topic of some basic principles regarding exchanging a vacation home or any other property which the taxpayer only occasionally uses as a dwelling. The detailed rules of exchanging will not be discussed in this article.

The IRS provides taxpayers with a safe harbor procedure under which the Service will not challenge whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment for purposes of Section 1031 even though the taxpayer occasionally uses the dwelling unit for personal purposes. Among requirements are both a minimum period of bona fide rental operation and a maximum period of use by the owner.

The basic requirements regarding the old property are as follows:

• The dwelling unit is owned by the      taxpayer for at least 24 months immediately before the exchange (the      “qualifying use period”) and
• Within the qualifying use period, in      each of the two 12-month periods immediately preceding the exchange:

• The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
• The period of the taxpayer’s personal use of the new dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
• For this purpose, the first 12-month period immediately preceding the exchange ends on the day before the exchange takes place (and begins 12 months prior to that day) and the second 12-month period ends on the day before the first 12-month period begins (and begins 12 months prior to that day).

The basic requirements of the dwelling unit that a taxpayer intends to be the new property in a Section 1031 exchange qualifies as property held for productive use in a trade or business or for investment if:

• The dwelling unit is owned by the      taxpayer for at least 24 months immediately after the exchange (the      “qualifying use period”) and
• Within the qualifying use period, in      each of the two 12-month periods immediately after the exchange:

• The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more, and
• The period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
• The first 12-month period immediately after the exchange begins on the day after the exchange takes place and the second 12-month period begins on the day after the first 12-month period ends.

Personal use of a dwelling unit occurs on any day on which a taxpayer is deemed to have used the dwelling unit for personal purposes. Time spent at the property while performing necessary repairs and maintenance may not have to be counted as time spent in residence.

Whether a dwelling unit is rented at a fair rental is determined based on all of the facts and circumstances that exist when the rental agreement is entered into. All rights and obligations of the parties to the rental agreement are taken into account.

The safe harbor rules provided applies only to the determination of whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment under Section 1031. A taxpayer utilizing the safe harbor in this revenue procedure also must satisfy all other requirements for a like-kind exchange and the regulations thereunder.

It is important to understand that Section 1031 provides a means of only deferring tax, not a means of tax forgiveness. The basis of the old property becomes the basis of the new property, where basis is most simply defined as:

Basis = Original purchase price + Amortizable purchase costs – Deductible purchase costs + Amortizable costs added to basis after purchase + Depreciable costs added to basis after purchase – Depreciation taken – Amortization taken

Deferral in itself has intrinsic advantages. First, it allows one to transfer significantly more equity of the old property into equity of a new property than would usually be possible if one sold the old property, paid tax on the gain and depreciation recapture, and invested the remainder into a new property. We say “most” of the equity because an exchange usually requires expenditures that would not be required for a sale and purchase. However, as these extra costs of exchanging are relatively small compared to the income tax due for a sale, an exchange is often extremely beneficial.

Even when the investor has to eventually pay the deferred taxes upon future sale of the property, the tax will be paid with inflated dollars, an advantage assuming that tax rates at time of exchange and at the time of eventual sale are similar.

The final exchanged property owned by the investor at the time of his death escapes income taxation because it passes to heirs with a “stepped-up” basis equal to the value at the time of death. Of course, for larger estates, those exceeding the exemption amount provided in the year of death, the government may get something from the estate (death) tax.

Summary

Within the specific boundaries of IRS rules, vacation homes may qualify for deferral of income tax. However, the above discussion should not be considered as tax advice. Readers are strongly advised to consult a competent experienced tax professional when considering Section 1031 transactions.

Asset Protection – Part 3  

In this third and final article of our series about asset protection we will discuss some additional issues related specifically to limited liability entities, using the term Limited Liability Companies (LLCs) because that is the entity most appropriate for most rental property owners.

Structuring For Continuity                      

It has often been said that the only things certain are death and taxes. Unfortunately, investors often worry more about and put more energy into minimizing taxes than they put into minimizing the impact on their investments in the event of their demise or their incapacity.

In Part 2 of this series we discussed the importance of having each real property, both rental and personal real estate, each operating business, and each group investment in which you have potential liability being owned by a separate limited liability entity.

What happens regarding all these different entities if you become incapable of managing them or if you die? Who will manage each entity? Will it be someone who you know, someone who has the necessary abilities, and someone who is trustworthy? Or will it be someone whose only qualification is being the brother-in-law of the clerk of the probate court?

Unfortunately, many Americans, including many real estate investors, do not have adequate estate planning in place. Even worse, some have none in place and the management and/or disposal of their assets will depend on the statutes of the particular states where they resided and/or those of the states where their properties are located. This article will not further consider the general issue of estate planning, but will briefly discuss a particular way of providing for preservation of assets and continuity of operating businesses, including rental properties.

Many estate planners and knowledgeable investors know that there are many advantages to having all assets being held in a Revocable Living Trust. Important advantages include (1) avoidance of probate in the event of death of the Trustor, (2) avoidance of conservatorship hearings in the event of incapacity of the Trustor, (3) easy succession of the Successor Trustees chosen by the Trustor, and (4) ease of distribution to beneficiaries upon death of the Trustor. Furthermore, the privacy that results from those items compared to open court hearings and publicly available records is very important to many and is a disadvantage only to the probate attorney profession and the accountants who might be chosen to join an attorney in milking the estate for a few years.

It would be advantageous to have a way of combining the estate planning and other benefits of a Revocable Living Trust with the liability protection of limited liability entities. One theoretical strategy that does this utilizes several levels of ownership.

We assume that an individual owns rental real estate, personal real estate, operating businesses, and various other assets that have risk associated with them such that they might be held by a limited liability entity.

First, we assume, for simplicity, that there are only three assets – A, B, and C.

Second, we assume that each of the three assets is transferred to ownership of a separate limited liability entity. For ease of discussion, we assume that each entity is a LLC, but keep in mind that they might be a mix of LLPs, ‘S’ Corporations, or even ‘C’ Corporations. Accordingly, the LLCs are called “Asset ‘A’ LLC,” ”Asset ‘B’ LLC,” and “Asset ‘C’ LLC.”

Third, we form a holding company called “Holding LLC” that is the sole member/owner of each of the three asset LLCs. Accordingly, Holding LLC owns the interests in the three LLCs, but does not own the real estate, business, or other asset itself. Holding LLC manages the Asset LLCs and their properties, including leasing vacancies and collecting income for each asset, paying all expenses of the Asset LLCs. Of course, each Asset LLC is kept separate, there is separate bookkeeping and accounting for each Asset LLC, and each Asset LLC has its own insurance policies as required for the asset it owns.

Fourth, the individual’s Revocable Living Trust, of which he/she is Trustor/Trustee, is made the sole member/owner of Holdings LLC which is a member managed LLC.

You should note that, in this case where we have assumed a sole Trustor for the Revocable Living Trust, no additional tax return need be filed during the life of the Trustor because the incomes of Asset LLCs flow through to Holdings LLC whose income flows through to the Revocable Living Trust and is reported on the individual’s 1040.

In addition to providing asset protection and all benefits of a Revocable Living Trust, the major benefit of the above strategy is that there is continuity of management of each asset with no requirement for Court involvement in event of incapacity or death of the Trustor. Obviously, the choice of Successor Trustee or Trustees is important, but no more so than if the assets had been held directly by the Trust.

There are other possible things that could be done as part of the above strategy for various tax or other reasons. For example, any equipment utilized by one or more of the assets (e.g., a pickup used for property maintenance) and/or real estate utilized by an operating business could be owned by another Asset LLC and leased to the other Asset LLCs as required.

The above discussion should not be construed to be advice for any reader. There may be specific circumstances under which this is not the best approach to asset protection or estate planning. Furthermore, there may be disadvantages of such an approach that overshadow any advantages. Also, court decisions and statute changes may require new or modified approaches to asset protection. Finally, it would be very important that everything be properly structured in order to avoid the strategy being considered a sham by a court if/when there is any event that might result in the strategy being challenged.

For the listed and other reasons, individual investors should consult competent estate and/or tax professionals regarding strategies discussed above or any other matters related to risk management, tax planning, and estate planning.

Some Final Thoughts

Life is full of risks to your health, safety, security, and finances. In our earlier Disaster Planning and Risk Management series we discussed some ways to avoid or minimize problems and manage financial risks. In this now completed Asset Protection series we have briefly discussed some continuity issues.

We strongly urge you to consider the issues covered in the three series and those of your personal financial advisors to see if you can improve the odds of keeping and passing on to your heirs whatever financial empire you have been able to build so far and might expand in the years ahead.

Once again, however, we advise you to seek competent professional advice regarding issues that are critical to your risk management needs and other personal and business related matters whenever it is prudent to do so.

Question 1

Does Youcheckcredit.com have an application form available?

Answer 1

A state specific application form is available from the member home page of Youcheckcredit.com after clicking “Forms by State” under the “Landlord Legal Forms” link. The MS Word version of the form can be customized by the landlord to meets the needs of a particular type of property. A landlord must, however, be careful to not include items that violate federal, state, or local fair housing laws when modifying or creating any document.

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Question 2

Do you have a standard letter that I can send to a tenant where I can list the reasons that they will not be getting their security deposit back?

Answer 2

We have a “Landlord Tenant Closing Statement” form available for most states. It is found by clicking “Forms by State” on the “Member Home Page” and then selecting the desired state.

However, there is no set form required by law in most states and certain situations might require different formats – e.g., it might vary with the type of property. Some states may have minimum basic standards, so you need to research your state’s landlord-tenant statutes regarding the matter.

The most important issues regarding return of security deposits and/or accounting for amounts not returned are basically as follows.

Many states require that the accounting for “amounts not being returned” must be fairly detailed and/or that the accounting include for each item charged either an invoice for work completed or a quote from a vendor when the work hasn’t yet been completed. Some states require advance notice of deductions that the landlord plans to make.

Most states have a deadline for when the accounting and any amount being returned must be mailed to the former tenant, most states specifying fewer than 30 days. Failure to meet the deadline can result in significant financial penalties, including in some states (1) prohibition of deduction from the deposit (could probably still file a lawsuit for the amounts) and/or (2) the landlord becoming liable to the tenant for damages, in some states specifying up to treble the amount of deposit that was not returned.

For states that require payment of interest on deposits being held, the interest amount must be stated in the accounting and included with the return of any part of the deposit being returned.

Because of the differences among state requirements, landlords must be certain to understand the laws of their particular states.

When the landlord does the work for items being deducted, the amount charged should be reasonable and related to the type of work being done. For example, the hourly rate for cleaning windows should be significantly less than the hourly rate for drywall repair that includes texturing and painting. Also, the cost of a task that might often be performed by a skilled licensed contractor should not exceed the amount a licensed contractor would have charged when the landlord spent a lot longer doing the work than would have a licensed contractor because it was the first time the landlord had tried such work.

An accounting should not be required when the full amount is being returned.

In all cases, I recommend that the accounting and/or check be sent with a “Certificate of Mailing” (not Certified Mail) in order to prove that it was mailed and that it was mailed in a timely manner. When the tenant has not provided a forwarding address, the mail should be addressed to the address where the tenant had lived. The tenant likely provided a forwarding address to the Post Office. If not or if an incorrect address was provided to the landlord upon the tenant’s departure, the mail should be returned the landlord and the returned mail should be retained unopened as proof of attempting to comply with the law.

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Question 3

How much should I charge for late fees on payment of rent? I live in Massachusetts.

Answer 3                                                         

From what I can determine, it appears that MA has no limit on the amount of a late fee that can be charged. However, an important fact is that MA statutes prohibit assessment of a late fee until the rent is at least 30 days late. Courts in most, perhaps all states require that the any late fee be adequately defined in the signed lease agreement.

Even though there may be no statutory limit on the amount of late fee that can be charged after 30 days of delinquency, you must understand that judges, when ruling on issues that are not specifically defined in statutes or have not been ruled on by a court of higher jurisdiction, will often limit landlord charges to what they consider to be reasonable and fair. Unreasonable charges, whether for late charges or other issues, can result in the judge slanting decisions in favor of the tenant.

Deposits & Fees, a Review – Part 2

We complete this two-part article with brief discussions regarding Security Deposits, Pet Deposits, and Last Month’s Rent. These three items are (1) usually truly deposits rather than fees, (2) covered to some degree by statutes in most states, and (3) usually of amounts that improper handling is likely to trigger conflicts.

Security Deposits 

A security deposit is money paid by the tenant to the landlord at lease signing and prior to the tenant’s occupancy of the rental unit. The general purpose of a security deposit is to provide the landlord with funds owed by the tenant if the tenant fails to pay rent on time and/or keep the rental unit in good condition. All states allow a landlord to collect a security deposit when the tenant moves in and to hold the deposit until the tenant moves out.

Security deposits are funds that legally belong to the tenant and remain a credit of the tenant during his residency unless and until some lease default by the tenant allows the landlord to utilize part or all of the deposit to reimburse the landlord’s financial loss resulting from the default. A security deposit is not rent. Collecting the first month’s rent upon move-in is not considered as part of the security deposit in most states. Accordingly, in the majority of states it is not included within the maximum limit of security deposit of the amount of security deposit that can be collected.

It is important that security deposits be collected before or at the time of lease execution and before giving possession of the premises to the tenant. It is also important that payments be in the form of cash, money order, or cashier’s check. Once the tenant has legal possession of the rental property, he/she can only be removed through eviction. Accordingly, if a personal check is worthless, it may take many hundreds of dollars and a couple of months’ time to legally regain possession and substantial additional dollars and time before the property is again readied for marketing and a new tenant is found.

How security deposits must be handled depends primarily on where the property is located. Most states have requirements related to security deposits, including one or more of the following:

• The maximum amount that can be required,
• Interest that must be paid on the deposit,
• Where the deposit must be kept,
• What can be deducted from the deposit,
• When the deposit must be returned and/or an      accounting of amounts not returned provided, and/or
• Penalties that may be imposed against landlords who      do not comply the rules.

Maximum Amount – Just over one-half of states limit the amount of security deposit a landlord can require. In states that specify a maximum, the amount typically varies from one to two times the monthly rent. Some states allow higher amounts for furnished units and/or for waterbeds. Some states specifically do not allow landlords to collect greater amounts by calling the additional amounts cleaning or redecorating deposits or fees or by collecting also a last month’s rent. Some states allow for an additional amount as a pet deposit, while most states do not consider this issue. If the state’s law is not clear on such issues, it is usually safest to consider the maximum as including everything except one month of rent.

Interest – There is a wide variety of specifications for calculating interest among states that require payment of interest on deposit. Some states specify a fixed rate, while others tie the rate to an index. Some states require payment of interest only after a certain length of tenancy, for example, one year.

Depository – While some states allow commingling of security deposits with other funds available for use of the landlord, many do not. Many states specify where deposit funds must be kept. A significant number of states specify the type and/or location of institutions and/or types of accounts in which funds may be deposited. Some states require that information regarding location be provided to the tenant.

Deductions – Most states specify the items for which funds can be deducted from deposits. Most states allow deductions for unpaid rent, damages, and replacement of missing items. Most, perhaps all states prohibit deductions for normal wear and tear.

Return/Accounting – Most states require that landlords return the security deposit and/or provide a detail accounting for any portion not returned. They must do so within a certain period following departure of a tenant, whether the departure was voluntary or non-voluntary. The period varies from 10 days to 60 days among the states, with one state only requiring a “reasonable” period.

Penalties – Many states impose significant financial penalties on landlords who do not perform in accordance with the law if the tenant pursues return of his security deposit in court. Penalties in various states include loss of the right to keep any part of the deposit and double or treble damages payable to the ex-tenant plus court costs and attorney fees.

Security deposits serve the purpose of protection as you turn over your income property asset to your tenant. Make sure that your security deposit adequately protects you from tenant damage or default within the limits of the maximum amount allowed by your state’s law. If you have specific concerns, such as pet damages, consider increasing the amount of security deposit to cover such damages, again with the total being in accordance with the law.

Landlords usually want to charge as much as they legally can, but the reality is that the market will have a direct impact on the amount. Generally the more the tenant has at stake, the more likely he will return the unit in good condition. Additionally, by collecting a larger deposit, the landlord has greater financial protection if the tenant should leave owing rent. However, even when still within allowable statutory limits, if the security deposit is set too high many potential applicants who otherwise might qualify to rent under your standards may not apply because of the higher move-in costs.

Most states limit the amount of security deposit that may be collected to an amount that is equal to one to two month’s rent. The amount may also be modified in some states for various factors such as whether the unit is furnished, the tenancy is month-to-month, or whether the tenant has water filled furniture or a pet.

It is advisable for landlords to always collect some amount of security deposit. The prospective tenant by committing to a security deposit is investing his funds as a return on his future actions. Without requiring some security commitment from the tenant, the tenant may feel no loyalty, no obligation to respect the property and fail to fulfill his responsibilities. The security deposit is a psychological tool that works to the landlord’s advantage.

Sometimes there are extenuating circumstances that require the landlord to allow possession without receiving all funds normally required before possession is given to the tenant. This might be that the landlord has found the perfect tenant but the prospect does not have the full amount required including first month’s rent, the requested security deposit amount, and any other deposits or fees allowed by state law. If you are willing to accept the inherent risk, collect as much money as you can before moving the tenant in.

It is usually best to apply the amount received toward security deposit first, other allowed deposits and fees second, and rent last. This is because it is usually easiest to obtain an eviction for unpaid rent than for the other items. The lease agreement document should be modified or include an addendum that states in detail the terms of deal, including how much is due for each installment payment toward amounts deferred, dates when due, and that failure to make agreed payments is grounds for lease termination.

Last Month’s Rent

A last month’s rent is actually a special type of deposit because the landlord will, by definition, be returning it by accepting it as payment for the final month’s rent. Some states allow collection of a last month’s rent in addition to first month’s rent and a security deposit. Other states consider the collection of any funds above a month’s rent to be a security deposit and regulate the maximum of the total security deposit.

Collecting the last month’s rent as well as the first month and security deposit, assuming that it is allowed by your state’s law, can significantly reduce the pool of applicants because the total of deposits becomes quite large. It can lead to misunderstandings and conflicts if not adequately defined in the lease agreement.

First, the tenant may assume that, since the last month is paid, there is no need to give notice or return property to good condition. Second, there is the issue of whether the tenant owes additional last month’s rent when rents increased during the tenancy. Judges often rule that the last month rent was already collected and that no additional monies can be collected even though the rent near the end of the lease was significantly greater than the amount originally collected as last month’s rent.

Some states designate that such funds labeled as last month’s rent can only be used for that purpose. That would mean that in the case of substantial damage to the unit and the security deposit has been exhausted, that such monies cannot be applied to the cost of damages, so the cost must be obtained separately after the fact, either voluntarily or through a lawsuit. A particular judge may rule this way even when the matter is not determined by statute.

In addition to adequate documentation, making sure that the amount of the security deposit and the amount of the monthly rent are not equal provides an additional argument against any claim by the tenant that he thought the security deposit would cover the last month’s rent.

Pet Deposits

It has been reported that more than half of U.S. renters have pets. Yet, only five percent of rental housing anywhere allows animals. That means that tenants are lying to landlords about having pets when they move in, or acquiring a pet in violation of the lease agreement later. Perhaps it happens because of a seemingly intractable attitude by landlords that pets cost them money so they refuse to even discuss the issue. Either way, landlords and tenants inevitably get into hassles that poison their relationship.

According, since the odds are high that pets will end up in your rental unit anyway, it is often better to voluntarily accept pets and protect yourself by discussing the pets in the lease, collecting a pet deposit, and charging a pet differential. You should also make sure that everything is clear regarding duties and responsibilities associated with pets by having comprehensive clauses in your lease or by separate Pet Agreement.

Although the majority of states do not address pet deposits, there are some states that do. Nebraska, for example, limits the amount of pet deposits to 25 percent of rent. The law does not appear to address the issue of refundable vs. non-refundable or discuss the need for an accounting. However, even Nebraska does not require the landlord to allow pets in his property. Since laws must usually be applied equally to all tenants in a property, Nebraska landlords would likely be required to either ban pets from all units of a particular property or limit the deposit to 25 percent for all units. Since the laws of those few states that do consider pet deposits vary significantly, you must check the laws of your state regarding the issue.

Question

Is there any legal reason why a landlord should not make copies of a prospective tenant’s SS card and driver’s license?

Answer

The shortest answer is NO! A longer short answer follows.

A landlord can request and make copies of any documents considered material to making an informed business decision. I considered the two items you mentioned to be at the top of the list and the minimum of what should be required. That being said, however, there are at least a few caveats.

First, as with most issues related to landlording, it is important that the same procedures be rigorously followed regarding all applicants, at least for a particular vacancy and better yet for a significantly long period that a change could be justified based on changing business conditions such as supply/demand in the rental market. The policies and reasons for change should be documented and retained for at least the statutes of limitations of relevant statutes, ordinances, and regulations related to fair housing and other discrimination issues.

Second, knowing that the applicant is who he says he is can be more important than any other qualifying criteria. A landlord will be safer to ask for at least two ID items (at least one being a government issued photo ID) out of a possible list of four or more items that are reliable sources – e.g., military ID card, passport, or other government issued ID. It is important, however, to choose items that are relevant and material to identity verification and to avoid any misrepresentation or fraudulent activity against the landlord or others. There are potential legitimate reasons why an applicant cannot come up with a particular requested document, so, in order to avoid potential discrimination claiims, it is important that landlords be flexible in allowing use of substitute documents.

Third, landlords, in order to avoid potential liabilities related to identity theft of an applicant or tenant, must be concerned about security of any such documentation ( both computer and paper records) and adequate destruction of it when no longer needed.

There’s a lot more that could be said on the subject, but hopefully, that’s enough for your needs.