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Accidental landlords & Sole Proprietorship

November 19th, 2008 at 10:49 am

Here is the first part of my paper. I hope to finish the section on Partnerships later tonight. I'm actually not as bored writing the paper as I originally thought.
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Legal & Tax Considerations in Establishing a Rental Property

Historically, real estate has been considered a safe investment vehicle yet the recent decline in the housing market has begun to challenge this idea.

Many homeowners in the years of subprime lending and easy credit purchased homes with little to no money down based on the notion that real estate would generate a guaranteed profit.

When the markets began to decline, many of those same homeowners found themselves owing more on their mortgage than the house was worth. Homes that were initially purchased as an investment to “flip” began sitting on the market longer and longer. Some homeowners have been forced to relocate due to job constraints. With the inability to make two housing payments many homeowners have decided to rent out their property to help off-set the cost of the mortgage, even if it means operating at a loss to ride out the market. The idea of renting a vacant home out can be a preferred alternative to a homeowner that may otherwise have to come to the closing table with thousands of dollars, foreclosing, or short-selling.

The aforementioned types of homeowners that have found themselves becoming a landlord are a growing trend of accidental landlords. A survey conducted in 2007 from CompleteLandlord.com found that 20% of landlords did not anticipate renting out their property when it was initially purchased .

Many accidental landlords, however, do not understand the complexity that can be involved in establishing themselves as a business. There are legal and tax considerations to evaluate in establishing a rental such as the type of business entity the property will fall under in addition to tax planning. This paper will discuss these different aspects that a prospective landlord should consider before deciding to get into the residential rental property business.

Sole Proprietorship

A sole proprietor is a single individual who is responsible for the ownership of the business. This form of entity is the easiest to set up because taxpayer can simply use his or her social security number as their tax ID number. Therefore, no paperwork is required to set up an organization under sole proprietorship. Due to the ease of establishing a sole proprietorship, this form of entity is also among the fastest growing forms of business entities.
Entities established under sole proprietors are not taxable organization.

Income and deductions for a sole proprietor are filed under Schedule C of the owner’s individual 1040 Form when filing. If a sole proprietor owns multiple businesses, a separate Schedule C is required for each business unit.

Income from sole proprietors is subject to self-employment tax which is levied to cover a self-employed individual’s Social Security and Medicare benefits. In 2007, self-employment tax to cover Social Security was 12.4% of self-employment income up to the $97,500 ceiling amount plus another 2.9% of total self-employment income to cover Medicare . This equates to a total self-employment tax of 15.3% on sole proprietors. To help offset taxes to sole proprietorship entities, self-employed individuals can deduct one half of the self employment tax rate from net earnings .

Another consideration that must be taken into account when establishing a sole proprietorship is estimated tax payments. Quarterly payments are required when a self-employed individual has an estimated annual tax that is $1000 or more . The estimated taxes owed must be paid in four installments throughout the year. If a taxpayer under-estimates his or her tax liability a non-deductible penalty may be applied to the amount of tax that was underpaid.

An individual with one rental property may be particularly attracted to sole proprietorship if he or she does not plan to be a landlord for very long or only wishes to have a few properties at most. Many individuals who became accidental landlords in the current housing crisis don’t intend on continuing to be a landlord once the housing market recovers. Instead, they have chosen to rent out their property as a way to off-set mortgage expenses in a down market .

However, this form of entity also has unlimited liability for the sole proprietor. If an individual wishes to sue the business, the personal assets of the sole proprietor can be included in a judgment if the court finds in favor of the plaintiff. This means that the sole proprietor’s personal home, vehicle, and bank accounts can be seized in the event of a lawsuit.

An accidental landlord who is not well versed in landlord tenancy laws for his or her state can find themselves liable for damages if certain laws are not adhered to. For example, under Virginia Code §55-248.23, a landlord must supply heat, water, hot water, and other essential services to a tenant. If a landlord fails to do and respond to the tenant in a timely manner, the tenant can recover damages in terms of the fair rental value of the dwelling or secure substitute housing. The tenant may also be entitled to attorney’s fees if proceeding under that section of the State of Virginia’s Code where a written notice is supplied .

The costs of litigation for a landlord as a result of not being well-versed in state and federal laws regarding residential rental units can be more expensive than an individual realizes. Therefore, an individual interested in establishing a rental property under sole proprietorship must carefully consider his or her risk tolerance and insurance policies when considering this form of entity because of the unlimited liability that accompanies it.

Rental properties can be extremely risky for accidental landlords that do not have the capital necessary to withstand repairs to the property and natural disasters. An accidental landlord can find themselves in a dangerous financial situation not only professionally but also personally if they are not adequately insured and protected with enough equity to cover the rental unit’s operations.

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