How to Operate Your Rental Properties Safely and Legally
An attorney friend of mine asked me about the regulatory and legal issues involved in owing and operating a rental property safely and legally. While putting a For Rent sign in the yard and collecting payments might seem easy, there are several other issues to address. To mitigate risk in your rental property investments, it’s important to consider tax, legal, and regulatory obligations.
*The following paragraphs discuss issues within our market in Arizona, but the principles can be applied regardless of location.*
Form an Entity
Consult with your CPA or Attorney regarding placing your rental properties in a separate entity, effectively forming a company to hold you rental homes. While this does afford a measure of liability protection, it can create unnecessary and unforeseen complexity and fees (tax and legal) that may not make up for the actual risk involved. Often with proper insurance you can mitigate the risk involved in holding your properties in your personal name. I have clients who hold property personally, and I have clients who hold property in Delaware LLP entities where you can't even discern who owns the home. Each structure has a time and place.
Example: Bob Jones owns the home, or the home is transferred into a company called 'Bob Jones Rentals, LLC'
Registration of a Rental Property
Check with your state, city and county to determine if there is a requirement to register the property as a rental. (If it’s an apartment complex, it was likely registered as such when the property was constructed.)
With a single family home, it was more likely registered as ‘owner occupied residential.’ You’ll need to let the State/City/County know that you now are using the property as a rental. There can be penalties for not registering the property correctly and there are reports of tenants and attorneys actually challenging the validity of a lease on a property that is not registered properly.
In Arizona, you can update your registration with Maricopa County here at a cost of $10. The county also has a link where your property can be reported if it is not properly registered. Ten dollars is a small price to pay to be safe and legal.
Paying Rental Tax
In Arizona, most municipalities charge and collect some sort of rental tax. Think of this as sales tax on the rent you collect. This tax needs to be paid by filing a form with the specific city.
Some cities do not require the tax if you have just one property and manage it yourself, some cities charge the tax regardless of how many you have or who manages the property. Check the Google machine and city in which your property is located. Our practice is to add this tax amount to the lease and charge it to the tenant. Our standard lease for has a place to add and calculate the tax.
For example, the City of Mesa charges 1.75%. This means if your property rents for $800, the tax is $14.00. You’ll need to pay this tax to the City of Mesa.
Municipalities are getting better at finding landlords who neglect to pay this tax. We recently contracted with a client who had managed his own home for 10 years and had not paid the tax. The city sent him a bill for around $1,200. How did the city find out? They matched the utility bills with the ownership records. Different names = rental property.
It’s critical to let your insurance carrier know that the property is a rental. If you want to be extra careful, send your agent some photos of the property. If you’re in the rental game you should have photos of all sides of the property and the interior anyway. Ask your agent to acknowledge that the type and size of coverage is indeed good for this particular structure. This is an inexpensive way to avoid surprises later. In the face of a disaster or emergency, this small bit of planning will pay off.
A couple of years back a successful businessman here in the Phoenix area had a disastrous fire at one of his companies. He had taken photos of his business and made sure that his coverage was adequate for the type and size of the equipment and structures involved. While there were some ins and outs to the insurance claim, in the end he was happy with the settlement and was glad that he had secured and confirmed the coverage he had.
Repairs and Maintenance
Don’t be a slumlord! Besides the laws against it and harsh penalties in Arizona, It presents unnecessary risk. There are going to be tenants that take advantage of you and don’t take care of your property, and this is frustrating. However, skimping on or withholding maintenance or repair as a retaliatory tactic is not only illegal, it’s fraught with the risk of losing a lawsuit or getting your name in the newspaper or on the internet for the wrong reasons. A good property manager will be honest with you as to the condition of your property and the cost of repairs needed. They’ll also weed out bad tenants and keep you from falling to the trap of renting poorly maintained properties. Ask yourself, "Do I want a business relationship with the person who would move into a home in this condition?"
The Feds: Tax Reporting
Rental real estate is one of the last places that you can make up some ground from a tax perspective. The way to do this is to make sure you are reporting your rental property income and expense properly on your federal tax return. Here's a link to the IRS site that discusses this. Given the number of type of transactions on a rental home (rent checks in, expense checks out) it's very unlikely that you'll be able to operate a rental property without reporting it on your tax return. You risk fraud penalties and criminal prosecution if you attempt to operate your rentals 'off book.'
Nearly every expense related to operating a rental property is deductible for Federal Tax purposes. This includes repairs, maintenance (be careful of 'improvements;' see your CPA), management fees, some trips to the property, property taxes, mortgage interest, etc. You'll also have depreciation expense which is great because you get a deduction without actually spending any cash!
While there are some regulatory, tax and legal considerations, owning and operating rental properties can be trouble free and financially rewarding. As with any business, it's important to have trusted advisers. Give Beehive a call with your Arizona property management or rental questions.