In a previous article I wrote about the tax structure efficiency that can come from the proper entity structure. The majority of companies don’t address this well, simply setting their structure in place and never reviewing to see if changes are warranted. Failing to do so can be costly at tax time.
Another common problem that occurs frequently for builders and real estate investors is a failure to structure for maximum protection of assets. When real estate is involved, the lines among builders, remodelers, investors, landlords and flippers often are blurry at best. We have worked with many clients who have started in one of these categories but have often migrated to the others. The ability to do the work that real estate holdings need is usually a strong incentive for a builder to also become a landlord who invests in his own rental properties, for example. If you or your company lives in more than one of these classifications, changes to your asset protection strategy may be called for to achieve maximum protection.
A builder may buy a property that needs some renovation to be worth substantially more than the cost of the property – a classic “flip” situation. Buy a property, fix it up and sell it for a profit within a few months is the normal intent. If this is the essence of this activity, managing new home construction and flipping existing properties within the same entity is usually fine. A construction project is a construction project – whether new build or remodel – and the construction process which leads to the sale of the property works similarly for any of these projects. No need for complexity or separate entities in most situations.
However, it often happens that a builder will buy a property to fix up and decide to hold it as a rental after the renovations. The property may be held for relatively short-term purposes (1 to 3 years) or long-term investment purposes (5 years or longer). Because the builder is “in the habit” of operating his construction company, most often he will acquire and renovate the property in the contracting company, for the convenience of using the same subcontractors and vendors that are used on every construction project. When the property is finished, tenants are found, rents are collected and an investment property is born!
The problem with this structure is that holding the investment property in the building company is an unnecessary risk. The building company is usually the highest risk venture that the contractor undertakes. The nature of construction creates some risk – sometimes things don’t go according to plan. Customers have problems after the sale is closed. Subcontractors are often hard to control and may perform sub-par work, leading to problems down the road. Any number of potential risks are part of the environment in which the building company operates.
Why does the builder hold a rental property? Because it is a good investment! The goal of a good investment is to maximize the value of the investment. This property has value in the beginning that we expect to grow while we own the rental. Holding valuable assets in a high-risk company can often subject the equity in the property to the claims against the building operation, if any occur. This is generally a poor structure for asset protection.
Another more subtle issue occurs in tax law that is affected by this as well. There is a very vague line between flipping properties and buying, holding for rental, then selling when the right buyer comes along. We have some investor clients who will buy a property intending to flip it. The right tenant comes along and the property becomes a rental. The client never really loses their intent to sell, so they sell the property within a short number of months later. This happens multiple times to this client during any particular tax year.
Is this activity flipping, or investing with an occasional sale? Does this happen once per year, five times per year or five times per month? Under the IRS rules, every company of this type has a primary identity – either an operating building company or an investing real estate activity. The tax rules for these two types of companies can be very different, especially when a property is sold. When these types of properties are blended together into one entity, this can make for a nightmarish IRS audit.
A proper asset allocation plan will address these issues with the intent of eliminating the lack of clarity.
Different entities with different purposes are essential in minimizing both the risk of exposure to lawsuit claims and the amount of taxes that are paid while these projects are managed by the contractor.
Don’t leave this to chance. Develop an intentional asset protection program to protect your family and properly structure your tax payments. Maintenance of activity in accordance with this plan will continue to provide financial rewards and peace of mind. In working with our clients, we find that accountants are uniquely positioned to provide accountability in this process.