When it comes to planning for real estate investments, many professionals fail to recognize the true needs of most real estate investors. It is often assumed that asset protection or tax reduction should be the focus of any planning. These are very important aspects of your investing, but as a real estate investor, you cannot lose sight of your goals and how to get there. If you are still working with traditional lenders to finance your deals, then tax returns, W-2 income, and business activity can significantly impact your ability to borrow. Real estate investors are often shocked to learn that they do not qualify for a loan despite having great income. This is often the result of your tax returns disclosing too much information to an underwriter or in a manner not recognizable for lending purposes.
The #1 common mistake? You run an active business as a Sole Proprietor, Partnership, or S-Corporation.
When you are in business for yourself and you operate through a flow-through entity (LLC taxed as a partnership or S-Corporation) or your personal name (sole proprietor), you are viewed as a greater risk for lenders. If you think you can hide that you operate your own business, think again. As you know, when applying for financing the underwriter asks to see a copy of your last two 1040s. Your 1040 will rat you out. On your 1040 the income from your flow-through business will appear as either 1040 Schedule-C income (sole proprietor) or K-1 income from an active business (Partnership and S-Corporation). The underwriter will then dive into your business activity looking for risk and evaluating how your business might fail resulting in your inability to repay the loan. Copies of business tax returns, profit and loss statements, balance sheets, and possibly bank statements will be required. Liquidity tests will be run in addition to who knows what other tests they come up with to make your life a ball of stress. Worse yet, if your business is flipping real estate then forget about it. When you know what they look for, you can give them what they want to see. Make yourself look like a W-2 employee who is not in business for himself by operating your active business through a C-Corporation.
Unlike the aforementioned entity types, a C-Corporation is a separate bracketed taxpayer, meaning it does not flow through to your 1040. Let that sink in for a moment… none of your business activity will be disclosed on your 1040 to the Mr. Sherlock underwriter. The only information they will have to work from is your 1040. Your 1040 will indicate you are just another W-2er punching the clock for your risk-taking employer. This type of structure is vital for flippers looking to dump their HML and develop lines with traditional lenders but is also very important for any business owner seeking traditional financing options for their real estate acquisitions. Always keep this in mind when dealing with underwriters. Less is better.
Next month, read how disregarded LLCs can hurt your commercial real estate deals and how the proper use of entities will boost your 1040 Schedule E income to increase your ability to borrow.
Anderson Advisors is an affiliate partner with Think Realty. Learn more at andersonadvisors.com.
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