Escrow instructions

The escrow officer prepares the escrow instructions that guide the transaction between the parties. The escrow instructions are derived from the specific terms found in the purchase agreement and in any other written documents mutually agreed upon by both the buyer and seller.

The escrow instructions are critical. To minimize surprises, carefully review the instructions before you sign them, because that’s the document that the escrow holder relies upon exclusively to determine what to do in the event of a dispute. Unless allowed in the escrow instructions, the escrow officer can’t make any changes or respond to any requests without a written agreement signed by all parties.

The escrow officer only performs items that are mutually agreed upon, in writing, by both the buyer and the seller. If the escrow officer receives conflicting information or requests, nothing happens until all parties reach an agreement or obtain a court order instructing the escrow officer. If something isn’t allowed in the escrow instructions, both the seller and the buyer must present a fully executed change order to the escrow officer modifying the agreement. In other words, make sure that the escrow instructions meet your expectations before you sign them.

Preliminary title report

Soon after the escrow instructions have been signed, your title company should send you a copy of the preliminary title report (or prelim). Have this extremely important document reviewed by an attorney unless you have a lot of personal experience and the prelim contains relatively few indicated items.

The preliminary title report indicates the current legal owner of the property and any mortgage liens, unpaid income tax liens, property tax liens, judgment liens, or other recorded encumbrances against the property. It also shows any easements, restrictions, or third-party interests that limit your use of the property such as the Covenants, Conditions, and Restrictions (C, C, and Rs) commonly found with planned unit developments, community associations, or condominiums.

Obtain and review copies of the detailed backup materials for each item so that you know exactly what’s encumbering the property. The approval of the preliminary title report by the buyer is one of the basic contingencies in most real estate transactions (see Chapter 13 for more on contingencies). You have the right (subject to certain time limitations) to cancel the purchase if the preliminary title report contains unacceptable items. Of course, you can also require the seller to have unacceptable items removed or renegotiate the price and terms in order to continue with the transaction.

The preliminary title report gives you a good idea as to whether the seller can provide you with marketable title to the property, but it isn’t the same thing as title insurance, which we cover later in this chapter.

Removing contingencies

As we discuss in Chapter 13, the purchase agreement should contain a number of contingencies that allow the buyer and seller the opportunity to cancel the transaction if certain items aren’t satisfactory. It’s the escrow officer’s job to track these contingencies and receive and follow the instructions from the buyer and seller. One of three things happens with contingencies:

• Contingencies can be approved or satisfied.
• The beneficiary of the contingency can unilaterally agree to waive or remove the contingency.
• A contingency can be rejected or fail.

Contingencies create a sort of option and are critical elements that can make or break a transaction. The purchase agreement and escrow instructions usually contain deadlines — the parties have certain rights pertaining to contingencies for a limited period of time. For example, the physical inspection contingency may provide only ten days to make the inspection; after that the contingency is considered approved (or satisfied) and the seller has the legal right to refuse access for a physical inspection.

The holder of the contingency option must notify the escrow officer at once in writing if the contingency is rejected or fails. Also, it isn’t the escrow officer’s responsibility to attempt to negotiate or mediate a resolution of any rejected contingencies or other deal-threatening issues that arise during the escrow. It’s up to the buyer and seller and their respective agents to come up with solutions and keep the deal alive.

Estimating the closing date

After all of the buyer’s and seller’s contingencies pertaining to items such as the financing, appraisal, books and records, and the physical inspection have been met or waived, the escrow officer advises the parties of the estimated closing date for the transaction.

Our experience is that when buying real estate, the process generally takes longer than planned. Therefore, if you’re intent on keeping your efforts to purchase your investment property from going awry because of unanticipated delays, make provisions upfront that provide the additional time to properly close the transaction. These provisions typically take the form of closing extension options and may involve an additional payment to the seller (new money above and beyond the current agreed payments in the proposed purchase) to cover their continued costs of ownership or an increase in the amount of funds paid by the buyer to show good faith. Often you have an agreement to release some or all of the earnest money or down payment to the seller as a nonrefundable payment.

This suggestion doesn’t mean that the escrow should be allowed to drag on for many months, but the more costly the property in escrow, the more likely you are to encounter unexpected challenges in satisfying or removing contingencies. Nonresidential property transactions tend to take longer to complete because the leases are more complicated to analyze and the buyer wants estoppel certificates from each tenant. (See Chapter 11 for more on estoppel certificates.) For example, lenders, with their layers of approvals and particular requirements, often cause unforeseen delays, including phase I reports (discussed later in the chapter) on potential environmental issues (particularly for nonresidential properties). Also, when the real estate market is active, appraisers can be backlogged and your appraisal delayed; your loan application won’t go far toward approval before the appraisal is complete.

No matter the size of your deal, negotiate the right to extend escrow. Some local Realtor boards have even developed a separate addendum that provides for extensions under certain conditions in order to enhance the likelihood of the transaction’s completion. These extensions usually provide for an initial 14-day extension at no cost if the closing is delayed due to issues beyond the buyer’s control. However, additional extensions are typically only allowed if the buyer compensates the seller for the equivalent of the seller’s mortgage payment and/or her lost rental income if the property is vacant.

Reviewing the books and records

Although savvy real estate investors conduct pre-offer due diligence and often receive a copy of a pro forma operating statement, you likely won’t have an opportunity to review the actual books and records until you’re formally under contract and in the due diligence period. Here are some things to make sure you have on hand before the deal is final:

• Seller-verified income and expense statement for at least the past 12 months: The actual income and expense history reveals any surprises that may not have been obvious from the pro forma statement you received from the seller. The best source of this information is the seller’s Schedule E from her federal income tax return — you can be fairly sure that she’s unlikely to overstate income or understate expenses to the IRS! After you have the most accurate numbers, you may find that the property has a serious problem with collections, or your anchor tenant’s suite has several large refrigerator units tied to your common electric house meter. This statement also gives you a good idea of where to look for opportunities to improve on the financial performance of the property.
• Seller-verified rent roll: A rent roll is a list of all rental units with the tenant name, move-in date, lease expiration date, current and market rent, and the security deposit. Also, get a seller statement that no undisclosed verbal agreements, concessions, or side agreements have been made with any tenant regarding the rent, renewal options, security deposits, payment of the utilities, or any other aspects of the financial terms of the lease or rental agreement.

• Seller-verified list of all tenant security deposits on hand: When acquiring a new rental property, follow state or local laws in properly handling the tenant’s security deposit. Many state laws require the seller and/or purchaser of a rental property to advise the tenants in writing of the status of their deposit. The law usually gives the seller the right to either return the deposit to the tenant or transfer it to the new owner.

  If the seller refunds the security deposits, you have the challenge of collecting deposits from tenants already in possession of the rental unit or suite, which is never easy. For this reason, strongly urge the seller to provide you a credit for the full amount of the security deposits on hand in escrow and have each tenant agree in writing to the amount of the security deposit transferred during the sale. This strategy streamlines the process and prevents you from having to recollect security deposits from current tenants. To avoid problems at the time of move-out, send your tenant a letter confirming the security deposit amount.

• Copies of the entire tenant file of each current tenant: Make sure you have the rental application, current and past leases or rental agreements, any options to renew or increase/decrease space, all legal notices, maintenance work orders, and correspondence for every tenant. The tenant-completed move-in checklist and/or photos/video showing the condition of the rental unit at lease commencement can also be extremely helpful when the tenant ultimately vacates the property. Also, insist that the seller advise you in writing about any pending legal action involving your tenant’s occupancy.
• Copies of every service agreement or contract: Review all current contractors and service providers the current owner uses (maintenance, landscaping, pest control, boiler maintenance, and so on). If you plan to terminate the services of a contractor or service provider, the seller may be willing to send a written conditional notice of termination indicating that, if the property sells as planned, that contractor’s services will no longer be needed as of the close of escrow. You can then find new contractors or maybe even renegotiate better terms with the current company.
• Copies of all required governmental licenses and permits: In many areas, rental property owners are now required to have business licenses, certificates, or permits or register their rental units with a rent control board. Contact the appropriate governmental office in writing and make sure that they’re properly notified of the change in ownership and/or billing address. Often these governmental entities have stiff penalties if you fail to notify them of a change in ownership in a timely manner. And they’ll eventually discover the change in ownership, because they usually monitor the local recording of deeds and receive notification of changes in billing responsibility from local utility companies. Make sure that you have current copies of all state and local rental laws and ordinances that affect your rental property.
• Comprehensive list of all personal property included in the purchase: This inventory may include appliances, equipment, and supplies owned by the current property owner. Remember: Don’t assume anything is included in the sale unless you have it in writing.

• Copies of the latest utility billing: Get all the account and payment information for every utility provider, which may include electricity, natural gas, water/sewer, trash collection, telephone, cable, and internet access. Prior to the close of escrow, contact each company and arrange for the transfer of utilities or a change in the billing responsibility as of the estimated escrow closing date. If provided with sufficient advance notice, many utility companies can have the meters read and/or the billing cutoff coincide with the close of escrow, preventing the need to prorate any of the utility billings between the owners.

  Also find out whether the seller has any deposits on hand with the utility company and whether you need to place a deposit for service. You may be able to simply handle the transfer of the deposit through escrow with a written deposit transfer acknowledgment from the utility.

  If a review of the property expenses indicates that utility costs are unusually high, you may want to insist on reviewing copies of the actual historical bills in order to determine whether there was a one-time variance or whether the property may benefit from conservation efforts.

• Copy of the seller’s current insurance policy (if available) and the loss history: One of the most important steps in the takeover of your new rental property is securing insurance coverage. Make sure that you have the proper insurance policy in place at the time that you legally become the new owner. Most lenders won’t fund your loan until they have written evidence that the property is adequately insured. Although the seller’s policy can’t protect you, request a copy of her policy or declaration of coverage and the loss history, because this information can be helpful to your insurance broker or agent when analyzing the property to determine the proper coverage.

When you receive this information, verify the accuracy of all records. Most sellers are honest and don’t intentionally withhold information or fail to disclose important facts, but the old adage “buyer beware” is particularly true in the purchase of rental real estate. Questions and issues that are resolved at this time can eliminate unpleasant and contentious disagreements with your tenants in the future. The takeover of your new rental property can be chaotic, but don’t fall into the trap of just verbally verifying the facts. Verify all information in writing and set up a detailed filing system for your new property. Ultimately, the best proof of the expenses is to insist on receiving copies of last year’s invoices to verify operating costs such as utilities.

With experience, you’ll be able to evaluate a property with surprising accuracy just by looking at the actual income and expenses. Look for discrepancies between the pro forma operating statement given to you during pre-offer due diligence and the actual income and expense numbers provided by the seller during escrow due diligence. There are many tricks that sellers and their brokers try to get past the unwary buyer. For example, watch for property tax numbers that will significantly increase upon a sale of the property if such taxes are based on the market value of a property or sales price. Also, be careful if the rent roll lists vacant units at higher market-rent rates that exceed the actual rental rate for the occupied units.

Inspecting the property

The condition of a property directly affects its value. The prudent real estate investor always insists on a thorough physical inspection before purchasing an investment property even if the property is brand new.

A new investment property may look good on paper and your pre-offer due diligence may reveal no legal or financial issues or concerns. But your investment is only as good as the weakest link, and a physically troubled property is never a good investment (unless you’re buying the property for the land and plan to demolish the current buildings).

You’re probably making one of the biggest financial purchases and commitments of your life. Though real estate investors by nature tend to be frugal, never try to save money by foregoing a proper physical inspection by qualified experts. Unless you have extensive experience as a builder and contractor, you probably have no idea what you’re getting into when it comes to evaluating the condition of most building systems. But even if you have experience, never rely on your own inspection entirely or try to save money by cutting corners. Even experienced and fully qualified real estate investors can find their judgment tainted by an emotional attachment to the property.

Our experience shows that an inspection usually pays for itself. Inevitably, you’re going to find items that the seller needs to correct that are greater in value or cost to repair than the nominal sum you spend on the inspection. This value isn’t just a marketing ploy by inspection firms, but it also isn’t a game that you “win” if you can offset the inspection cost by finding enough items that the seller must correct or provide credit in escrow for — as some real estate gurus seem to believe. Instead, the inspection is a serious matter and not just a way to squeeze more from the seller.

The best result is if the inspection reveals no problems. Although you’ve spent money, it’s a great relief to know that your property (at least at the time of the inspection) is in good condition. That doesn’t mean there won’t be repair or replacement items that need your attention in the future, possibly even the very near future. In Robert’s early days in real estate investing, he worked for an apartment developer whose favorite saying was “To own is to maintain!”

Virtually all real estate purchase contracts provide that the transaction can be canceled without penalty or loss of the earnest money deposit if the buyer’s physical inspection isn’t satisfactory. But often, additional negotiations between the buyer and seller result. It’s this competently prepared written inspection report that provides the information you need and serves as the basis to go back and ask the property seller to fix the problems or reduce the property’s purchase price (see the “Negotiating Credits in Escrow” section later in the chapter).

Savvy real estate investors actually have a two-step inspection process with their initial pre-offer walk-through of the property as a prelude to even making the offer. If the offer is made and accepted, the professional inspection is to identify any deal-killer problems with the property or any items that warrant renegotiation. You’re looking for two types of defects:

• Patent defects: Defects that are readily visible by simply looking at the property. Patent defects may be a broken window, cracked drives or walks, or a leaking faucet.
• Latent defects: Hidden and hard-to-see defects that require intrusive or even destructive testing. Examples include corroding copper pipes underneath the slab, or ceiling or window leaks that the owner has cosmetically repaired through patching and painting to hide from potential buyers. That is why disclosures are so important.

Qualifying the inspectors

Just like selecting the closing agent, many real estate investors pick inspectors as an afterthought or simply take the recommendation of their real estate agent. But inspect the property inspectors before you hire one. As with other service professionals, interview a few inspectors before making your selection. You may find that they don’t all share the same experience, qualifications, and ethical standards. For example, don’t hire an inspector who hesitates or refuses to allow you to be present during the inspection or won’t review the findings with you upon completion of the inspection.

The inspection is actually a unique opportunity for most property owners and, because you’re paying, we strongly recommend that you join the inspector while he’s assessing your proposed purchase. What you learn can be invaluable and may pay dividends throughout your entire ownership. When an unscrupulous contractor later tries to tell you that you need to completely replumb your property, you can recall that your property inspection revealed only isolated problems that can be resolved inexpensively. (Of course, inspectors, especially ones who aren’t good, can make mistakes, so you should also dig into discrepancies raised by different real estate–related people. In other words, get a second opinion.)

About half of the states now have a license or certification requirement, whereas a few only have trade practice guidelines. This regulation is all relatively new because in 2000, virtually no governmental licensing or supervision of inspectors existed. Regardless of whether your state has strict licensing or certification requirements, every real estate investor needs to look out for her own interests and look for telltale signs of potential problems. Red flags include inspectors who are affiliated with a contractor, offer a special discount if you call who they recommend, or credit their inspection fee toward work.

Only consider full-time, professional inspectors. Hire an inspector who performs at least 100 comprehensive inspections per year and carries errors and omissions insurance. Such coverage isn’t cheap and is another key indicator that the person is working full-time in the field and is participating in ongoing continuing education.

Many inspectors are licensed general contractors, but not all home inspectors have designations or credentials specifically relating to inspecting real estate. One of the best certifying trade associations for professional property inspectors is the American Society of Home Inspectors (ASHI), which was founded in 1976. In addition to home inspections, many ASHI members are qualified and experienced enough to assist you with your due diligence physical or structural exterior and interior inspection of multifamily residential properties and all types of commercial properties. You can find certified inspectors and more info about the inspection process including tips and checklists at www.ashi.org.

Some individuals or companies adopt names that at first glance may indicate adherence to certain professional practices. For example, a fictitious but potentially misleading name is “Professional Property Inspection Association.” Do some research to find the best state or regional association and one whose qualified members adopt a code of ethics. For example, in California, the California Real Estate Inspection Association (www.creia.org) is the group that offers education and designations for real estate inspectors.

Review a copy of inspectors’ résumés to see what certifications and licenses they hold. A general contractor’s license and certification as a property inspector are important, but also find out whether they’ve had any specialized training and whether they hold any specific sublicenses in areas such as roofing, electrical, or plumbing. These can be particularly important if your proposed property has evidence of potential problems in any of these areas. For example, if a property has a history of roofing or moisture intrusion problems, an inspector who’s a general contractor and roofer is an extra plus.

The inspection report must be written. To avoid surprises, request a sample of one of the recent inspection reports that has been prepared for a comparable property. This simple request may eliminate several potential inspectors but is essential so that you can see whether an inspector is qualified and how detailed a report he will prepare for you. Check out Figures 14-1 and 14-2 for a sample interior inspection checklist.

The advent of digital photography is a boon to property inspectors and makes their sometimes mundane and difficult-to-understand reports come to life. Select a technologically savvy inspector and require her to electronically send you her report, including digital photos documenting all the conditions noted. Recently, some inspectors have begun using advanced, non-invasive technology via an infrared or thermal imaging camera to produce images of heat radiation and identify energy efficiency concerns and electrical issues, as well as moisture intrusion scans inside walls or around plumbing fixtures. With the report in the electronic realm, it’s a simple process to email this information as needed.

Although the cost of the inspection should be set and determined in advance, the price should be a secondary concern because inspection fees often pay for themselves. Just like many other professional services, there is a direct correlation between the pricing of your inspection and the amount of time the inspector takes to conduct the inspection and then prepare the report. If the inspector only spends a couple of hours at your new 20-unit apartment building, the report will surely be insufficient and your money not well spent.

Finally, require the finalists to provide the names and phone numbers of at least ten people who used the company’s services within the past six months. Randomly call and make sure that these clients were satisfied and that the inspector acted professionally and ethically.

Sole proprietorship

A sole proprietorship is certainly the easiest and cheapest form of ownership and requires no special prerequisites. Simply have title to the property vested in the name of an individual person on the deed, and you have a sole proprietorship. Other advantages include the following:

• Exclusive rights of ownership: You have complete control and discretion over the use of the property and the right to sell, bequeath, or encumber the property any way you see fit.
• Minimal legal costs to establish: You may need a business license or to register with your state as a DBA (doing business as), but generally there are no additional legal expenses to set up and maintain a sole proprietorship.
• Simple record keeping: This can be a negative if you aren’t disciplined.

However, sole proprietorship also has its downsides, including the following:

• Unlimited liabilities: You have no legal protections against lawsuits or other claims (even if caused by an employee), and your name is easily obtained through public records. Other forms of ownership can create a barrier between you and claimants and creditors.
• No real tax advantages: Sole proprietorships offer no real advantages in the area of death and taxes! All income and expenses are reported directly on your personal tax return, and there is no preferential tax treatment or avoidance of the probate courts in the event of your death.
• Possible marriage complications: A sole proprietorship can become complicated if you’re married or later get married and intend to keep your investment property as a separately held asset. Check with your tax advisor before making any significant changes in your marital status because you need to keep detailed accounting records to avoid any commingling of funds from community property that could create an interest for a spouse in the real property.

Joint tenancy

Joint tenancy is a way in which two or more individuals may hold title to a property together where they own equal shares of the property. Joint tenancy is only available to individuals (not legal corporate entities) because a unique feature of holding title in a joint tenancy is the right of survivorship. Upon the death of one of the joint tenants, the entire ownership automatically vests in equal shares to the surviving individual or individuals without going through the probate process.

In order to form a joint tenancy, there must be unity of time, title, interest, and possession. Unity of time means that all joint tenants must take title by the same deed at the same time. Another requirement is that each joint tenant own an equal interest or percentage of the property — so if you have two joint tenants, they each own 50 percent, whereas four joint tenants would each own 25 percent of the entire property. Any ownership of a property in disproportionate shares can’t be a joint tenancy.

Each joint tenant is legally entitled to the right of possession and can’t be excluded by the others. Some states specifically require the joint tenancy deed to include the wording “joint tenants with right of survivorship.”

One concern is that joint tenants can sell, bequeath, or encumber their portion of the property without the consent of the other owners. It’s possible for the joint tenancy to be terminated in the event of a judgment lien or bankruptcy. Likewise, a new joint tenant can only be added by executing a new deed. Income and expenses from operations of the property are reported on each individual’s tax return.

A unique advantage to joint tenancy, besides the right of survivorship, is that you get a stepped-up basis on your deceased joint tenant’s portion of the property. Receiving a stepped-up basis means that the taxable basis is increased for the portion of the property owned by the deceased joint tenant to the current market value at the time of death. This ability can be a tremendous benefit for the surviving joint tenants and allows them to sell the property with significantly lower taxes.

For example, suppose two joint tenants buy a property for $200,000. Many years later, one of the joint tenants dies, and the property is appraised at $300,000. The new adjusted basis for the surviving joint tenant is $250,000, representing the original basis of $100,000 plus $150,000 (one half of $300,000) for the deceased joint tenant’s interest. This basis is important when calculating the gain or loss upon sale of the property, so having the basis increase can dramatically lower your taxable capital gain (see Chapter 18 for details).

Although marriage isn’t a requirement to use this method of holding title, traditionally, joint tenancy has been the most common way for married couples to hold title to investment properties. One of the primary advantages of joint tenancy is that the death of one spouse can result in a complete step-up in basis to the fair market value at the time of death rather than just a step-up for the portion owned by the deceased joint tenant. Depending where you reside, states have additional options for married couples, such as community property or tenants by the entireties.

Tenancy in common

One of the most common forms of co-ownership is tenancy in common (also known as tenants in common or TIC). A tenancy in common is the ownership of real property in which several owners each own a stated portion or share of the entire property. In most states, if the deed is silent as to the form of ownership, tenancy in common is the presumed method of holding title.

Unlike joint tenancy, in a tenancy in common, each owner can own a different percentage, can take title at any time, and can sell his interest at any time. Another distinguishing characteristic is that each owner has complete control over her portion of the property and can sell, bequeath, or mortgage her interest as she personally decides without any feedback from or recourse for the other owners. Further, upon her death, her share becomes part of her estate and can be willed as she sees fit.

Tenants in common products are now being aggressively touted by financial advisors as an investment product of choice for the owners of appreciated real estate who are looking for a more passive investment without the challenges of property management. These investments offer the investor a way to own fractionalized interests in real estate and can be structured as direct ownership of property with a deed for their interest, or many are actually security interests. The sponsored tenants in common products usually have a management agreement or governing document to address issues of control and avoid the problems discussed later in this chapter.

Tenancy in common is a popular way to hold title for real estate investors but can be a problem unless there are clear understandings, preferably in writing, as to the asset and property management decisions of operating the property. But even then, problems and challenges are possible:

• Death of an owner: You may find that a co-owner has left his interest in a property you partially own to someone that you don’t get along with or one who has different or incompatible goals and expectations for the property.
• Sale by an owner: Because each owner has equal rights of control over the property, serious conflicts may arise when one owner wants to sell or borrow against the property. Or an owner may decide to sell to an individual or entity, which disrupts the spirit of cooperation among the various owners.
• Financial problems of an owner: You’re financially tied to your co-owners for better or worse even in their activities other than the jointly owned property. A judgment against one of the co-owners can lead to the creditor foreclosing on that co-owner’s interest in the property to satisfy a monetary judgment. Or a bankruptcy by one co-owner can lead to the bankruptcy court ordering a forced sale of the property to satisfy the bankruptcy creditors unless the other co-owners are willing to pay off the creditors and buy out the financially challenged co-owner.
• Different plans: Each co-owner may have different goals and strategies for the property or the way it should be managed. With tenancy in common ownership, absent a written governing document, there’s no majority rule or simple way to arbitrate differences in opinions. Because a single owner can thwart the mutual plans of all the others, disagreements about whether to borrow money by using the property as collateral or whether to sell the property can result in a legal action. Robert has served as a court-appointed referee in several of these actions (called partitions), and they can be quite stressful for the parties — who can’t seem to agree on anything!

Income and expenses from operations of the property are reported on the individual’s tax return, but a problem with tenants in common is that new investors acquiring a TIC interest may not qualify for the tax-deferral benefits generally associated with a 1031 like-kind exchange. The promoters and sponsors of the TIC programs often portray these investments as the answer to all your needs, but in reality, they aren’t giving folks the full story. Buyer beware — before making any move, consult your tax advisor about the tax ramifications of selling appreciated real estate and investing the proceeds into a tenants in common or fractionized interest. Liquidity (ability to sell your interest) is also a concern because there are currently no public secondary markets for tenants in common interests. See our comments in Chapter 4 and remember: If it seems too good to be true, it probably is!

Partnerships

A real estate partnership is a form of business enterprise in which two or more persons join together to pool their capital and talent to purchase, manage, and ultimately sell real estate. Investors in a real estate partnership don’t have actual title or ownership interest directly in the property but actually own a partnership interest.

Although a partnership interest technically is transferable, a partner seeking to sell will find few, if any, ready buyers and will likely have to severely discount his asking price below its intrinsic value. The best option is to negotiate a buy/sell agreement prior to acquiring any properties in which the terms are thoroughly discussed and each partner has the ability to leave at any time based on predetermined criteria. Often, such agreements call for the other partners to purchase the outgoing partner’s share.

A partnership isn’t a corporation, and generally takes one of two forms:

• In a general partnership, each partner has the right to fully participate in the management and operations of the property, and each partner is fully responsible for the debt, legal obligations, and any business losses incurred. General partnerships are easy to establish, but a serious concern is that each individual partner is able to contract on behalf of the partnership and all partners are then legally liable for these actions. Another disadvantage of a general partnership is that the death, bankruptcy, or withdrawal of one of the general partners may require the dissolution and complete reorganization of the general partnership.
• A limited partnership consists of one or more general partners along with one or more limited partners. The general partner (who can be an individual or a corporation) handles management and operations and has unlimited liabilities. The limited partners are restricted from participating in management and operations of the property and only have their actual cash investment at risk. Limited partnerships have been popular because they allow folks to invest relatively small amounts into larger real estate deals. Also, a limited partnership can continue on even if one of the partners dies, files bankruptcy, withdraws, or sells his partnership share.

Partnerships have been a common and successful way for individuals to work together to purchase larger real estate investment properties. Often, they bring together individuals with complementary resources and skills. For example, a good partnership may include a real estate broker, a property manager, a real estate financial analyst or appraiser, and a real estate lender. The complementary skills of this partnership offer insight into each phase of the investment. In another common arrangement, one of the partners doesn’t have any real estate expertise or acumen, but instead provides a significant portion of the investment capital.

The expertise of the general partner can be an advantage of real estate partnerships over TICs, where the TIC governing documents typically provide that each owner can vote his proportionate share and the majority makes the decisions. The problem is that a collective majority in a TIC may not have the real estate experience to make the best decision. In a real estate partnership, the owners of minority interests often find they have little input into the major decisions of the partnership (such as refinancing and selling or exchanging the property). But this hands-off approach can actually be beneficial and a lot less stressful if the general partner is competent and knows what she’s doing.

From a taxation standpoint, real estate partnerships must prepare an IRS form 1065 tax return and pass through the respective share of all profits and losses and depreciation to each individual partner. Each partner then reports these numbers on her personal tax returns. At the time of death of a partner, there are several tax-related issues concerning the handling of the partnership interest, so consult a tax advisor.

Limited liability company

Now available in all 50 states, the limited liability company (LLC) is a hybrid form of doing business that combines characteristics of a partnership and a corporation. This setup is an unbeatable combination for many real estate investors and a great way to hold title to real estate holdings. LLCs have essentially replaced corporations and partnerships as the most common way to hold title to real estate because they offer the advantages of allowing each member to have a say in the management while extending limited liability to all members, without the burden of double taxation that occurs with corporations. (Profits of corporations are first taxed at the corporate level, and then the profits distributed to individual shareholders are taxed again on their personal returns.)

An LLC is a separate entity like a corporation and therefore carries liability protection for all of its members, but it can be structured like a partnership so that the taxation flows through to each member individually. This feature simply requires the LLC to declare itself a joint venture with the IRS and indicate how it wants to allocate the taxation of income and expenses. Like a partnership, an LLC is required to prepare and file an IRS Form 1065, Partnership Tax Return, unless it makes the joint venture election.

Check with your own tax advisor, but many advisors recommend that their clients use a limited liability company because it offers the best of both worlds — limited liability plus favorable and simplified tax treatment. Every state has its own requirements. Contact an attorney to have her prepare the articles of organization and an operating agreement (which are usually filed with the secretary of state).

The owners of an LLC are called members and can be virtually any entity, including individuals, partnerships, trusts, corporations, pension plans, or even other LLCs. Typically, LLCs have multiple members that can own different percentages; however, virtually all states permit single-member LLCs (but not without some potential issues with the IRS that you should discuss with your tax advisor in advance). Fortunately, a husband and wife are considered two members when forming an LLC.

Despite all these advantages, seek the counsel of an attorney who specializes in the formation of LLCs to give you help with the following issues:

• IRS limitations: IRS regulations have some limitations on the characteristics of the LLC. An attorney can advise you on the best structure to establish — one that emphasizes the importance of limited liability and centralized management while foregoing continuity of life and easy transferability of interests. In addition to filing a partnership tax return with the IRS, most states also require an annual or biennial report of activity along with filing fees, withholding, or even franchise fees; however, many states don’t have any minimum charges or they are equal to or less than $100 per year.
• Costs: The costs can be much greater than for other forms of ownership. Be sure to consult with a local tax advisor for details on the typical costs for operating an LLC in your state. Currently, the highest base cost for an LLC is found in California: a minimum franchise tax fee of $800 per year plus additional taxes based on gross receipts.

Corporations

A partnership consists of people, but a corporation is a legal entity owned by one or more shareholders. The most well-known form that corporations take is that of public corporations like Google and Johnson & Johnson, which have shares traded on a stock exchange. Real estate investors can also create their own private or closely held corporations to own real estate.

A real estate investor can establish a corporation by filing articles of incorporation and bylaws with the appropriate state agency, usually the secretary of state’s office. Corporate requirements vary from state to state, so consult your tax and legal advisors prior to implementing a corporate form of ownership for real estate assets. Nevada and Delaware are two of the more popular states in which to incorporate, but your legal and tax advisors can tell you if these states provide any advantages for your personal situation. Typically, you’re best off to incorporate in your state of residence.

The appeal for real estate investors to form a corporation is that there is limited liability for shareholders. The owners of a corporation actually own stock, which is personal property. Thus, when corporations own real estate, the shareholders don’t actually own the real estate. They own shares of stock in the entity that legally owns the property. Therefore, the most a shareholder can lose is her equity investment.

A disadvantage for many real estate investors is the initial expense to have an attorney draft the organizational documents. Then there are the costs to cover the rather extensive reporting requirements at both the state and federal levels to maintain their corporate status. If the corporation isn’t sufficiently capitalized or fails to meet all the detailed organizational and reporting requirements, creditors or lien holders can pierce the corporate veil and seek personal liability for individual shareholders.

Two types of corporations are available:

• C Corporation: Although C Corporations (the most well-known and popular type of corporation) have the advantage of continuity of life in the event a shareholder dies, their downside is the double taxation of profits. Another negative is that if the corporation has losses, it has to carry them over to the next tax year because the shareholders can’t use C Corporation losses on their personal returns.
• S Corporation: A primary benefit of this type of corporation is the ability to avoid double taxation by passing through the profits and losses directly to the individual shareholders. But S Corporations are rarely used in the ownership of real estate because their primary disadvantage is that a liquidation of the S Corporation is a taxable event. So even if the shareholders of the S Corporation can agree to an equitable distribution of the assets, the IRS deems the liquidation as taxable and the shareholders must pay capital gains taxes and possibly sell some of the assets. (Note that in a liquidation of an LLC, the assets may be distributed to the members without a taxable event occurring.) There is also difficulty for shareholders that aren’t involved in the day-to-day operations. The IRS requires material participation (an IRS term that indicates whether an investor worked and was involved in a business activity on a regular basis) for the realization of tax benefits.

Only consider using a corporation to hold your real estate assets if you’re willing to pay for the professional, legal, and accounting advice upfront and on a continuing basis to make sure that the protections of limited liability can’t be violated. Although corporations have some inherent advantages, the drawback of double taxation and the ongoing technical requirements and expense to maintain the corporate status make utilizing the corporation entity unsuitable for the average real estate investor.

Estimated closing statement

Several days before the projected date for the close of your escrow, both the buyer and the seller receive a copy of the estimated closing statement with the various charges. You may receive this statement at the time you sign some or all of the documents, or it may be sent to you separately. This is an extremely important document because this is the best time to raise any issues or concerns if you feel that an error has been made.

The estimated amounts can, and usually do, change slightly. Often the escrow officer or closing agent estimates these expenses a little on the high side because any shortage of funds prevents the escrow from closing, but any overage can easily be credited or refunded back to the buyer or seller.

The buyer should pay particular attention to the estimated closing statement because it indicates the funds expected to be received from the lender or credited from the seller if there’s seller financing. It also indicates the amount of additional cash funds that the buyer needs to deposit in the form of a wire transfer, cashier’s check, or other certified funds. The buyer must provide these good funds in plenty of time for the escrow to close — your personal check will take up to a week to clear and credit cards and PayPal or Venmo aren’t accepted! Remember: If you have a large sum of money deposited in escrow, arrange for the escrow company to place the funds in an interest-bearing account.

Title insurance

Title insurance has evolved to become a vital element in most real estate transactions. Title insurance companies track all recorded documents and transfers of interests in real estate so that they can issue title insurance — policies that assure the purchaser that the title to the property being transferred is legally valid and unblemished. This kind of title is commonly referred to as a clean and marketable title. Title insurance is like any form of insurance in that it defends and pays the claims made against the insured. There are two types of title insurance policies issued in most transactions:

• The seller provides one to the buyer to protect herself against claims that the purchase of the property wasn’t a marketable title. For example, maybe the heir to a former owner suddenly claim that there was a fraudulent transfer of the property years ago. If you bought title insurance when you purchased the property, the title company defends any legal action or compensates you in the event that the claim is valid and you lose the property.
• Mortgage lenders require title insurance to protect against someone else claiming legal title to your property. The lender provides funds toward the purchase of the property and wouldn’t be protected if the property ownership were to change based on a claim of an improper transfer of title. There are many ways that a title can be transferred improperly — for instance, when a husband and wife split up and the one who remains in the home decides to sell and take off with the money. If the title lists both spouses as owners, the spouse who sells the property (possibly by forging the other’s signature) has violated the law. The short-changed spouse can reclaim rights to the home even after it has been sold. In this event, both you and the lender can get stuck holding the bag in the absence of title insurance.

Most state insurance departments monitor and regulate title insurance companies because a company’s ability to pay claims is always important. Although title insurers rarely fail, and most states do a good job shutting down financially unstable ones, check with your state’s insurance department if you’re concerned. Title insurance companies receive ratings from insurance-rating companies, so you can ask the insurer for copies of the latest report.

Don’t simply use the company that your real estate agent or lender suggests — shop around. Because many title companies provide escrow services, you need to watch out for companies that quote very low prices on one service and make up for it by overcharging in other areas. When you call around for title insurance and escrow fee quotes, get a handle on all the charges; there may be miscellaneous or hidden administrative fees that can sneak up on you and become major items — document preparation, notary services, courier fees, and express mail. If you find a company with lower prices, consider asking for an itemization in writing so that you don’t run into any surprises.

Check with your title insurance company for special riders (clauses) that save you money if you’re buying a distressed investment property with the intention of quickly renovating and selling the property in less than 24 months. (That’s two title insurance policies — you pay for a lender’s title insurance policy as the buyer and then a seller’s title insurance policy when you sell the property.) These special policies typically cost you 10 to 20 percent more upfront but can be a real bargain if you can avoid having to purchase a brand-new title policy for a short holding period.

Property insurance

You must have insurance, often one of the larger expenses for investment properties. Unless you purchase the property entirely for cash, you can’t close the transaction and take over the property until you have a certificate of insurance in place. Your lender, or even the seller if he’s providing any financing of your purchase, will prudently insist that you have adequate insurance coverage with policy limits that effectively protect your financer’s collateral or financial interest in the property.

In accounting terms, property insurance is a fixed expense (like your property taxes), which means that although you may be able to turn off the natural gas (a variable expense) when your property is unoccupied, you must have insurance coverage — even if your property is vacant. In fact, insurance is likely more important if your property is vacant for an extended time frame.

In order to avoid surprises in your cash flow, determine the cost of insurance while you’re still in your due diligence phase of the transaction. At this point, you retain the ability to cancel without penalty if you find that proper insurance coverage is either not available or priced way too high.

Another benefit of getting your insurance early in the due diligence process is that your insurance agent or an underwriter from the insurance company may even inspect the property before providing you with a quote. Of course, any inspection by the insurance company is limited in scope and is never a substitute for your own inspection or the detailed written inspections you need from your property inspector and other industry professionals or experts (see “Inspecting the property” earlier in the chapter). But it can be important to know whether the insurance company is going to require any upgrades or changes to the property as a condition of offering insurance.

For example, many companies no longer write policies for multifamily residential properties that have balcony- or pool-fence wrought-iron railings with pickets spaced more than 4 inches apart, due to the potential hazards to small children. The cost to correct this condition can be expensive, and you would want to include such costs in your negotiations with the seller or at least include the amount in your capital budget. (We discuss the role of insurance in an effective risk management program in Chapter 16.)

You may trust your insurance broker or agent, but don’t allow your escrow to close until you have written documentation confirming that your property insurance coverage is in force. It may seem improbable, but many properties have suffered a catastrophic loss or liability claim in a matter of hours after the property changed hands and the new owner’s insurance coverage wasn’t yet in place. Robert was an expert witness in a case where an owner thought his insurance agent had placed earthquake coverage on his new apartment purchase only to discover a few days after a devastating earthquake had substantially destroyed his building that the request for coverage was never sent in!

Final closing statement

Just before your transaction is complete and escrow is closed, you receive a closing statement from the escrow officer. Besides the actual purchase price, there are several expenses incurred in the process of purchasing real estate that must be worked out between the buyer and the seller. For example, the seller may have paid the property taxes for the balance of the year, and the buyer should reimburse him for the amount attributable to his ownership period after the close of escrow.

The buyer and seller need to pay some expenses, such as escrow and recording fees. Who pays what is usually outlined in the escrow instructions and is determined by a combination of the purchase agreement negotiations between the parties and custom and practice in the local real estate market. Table 14-1 contains a breakdown of the allocation of expenses that are typical in the purchase of investment properties.

In addition to the allocation of expenses between the buyer and seller, the final closing statement contains credits (items that accrue to the benefit of the party receiving the credit) and debits (items that are paid out of escrow on behalf of the party being debited). Table 14-2 has a breakdown of the usual accounting of the debits and credits on the closing or settlement statement.

The day before you close on the property, take a brief walk-through to make sure that everything is still in the condition it was before and that all the fixtures, appliances, window coverings, and other items the contract lists are still there. Sometimes, sellers ignore or don’t recall these things and consequently don’t leave what they agreed to in the sales contract.

The importance of conducting a final property inspection prior to closing escrow is illustrated by one of Robert’s expert witness cases. The buyers of a single-family home failed to close escrow as planned because they decided they didn’t want to put the 20 percent down payment in cash but instead were negotiating with their mortgage broker to arrange a second loan that could be combined with their first trust deed to give them 100 percent financing. The seller had moved out on the original estimated closing date, and the home sat vacant for several weeks until the buyers were able to arrange and fund the second loan. With the transaction dragging on past the expected close of escrow, the anxious buyers failed to inspect the home that one last time before finally closing escrow. Unfortunately, sometime between when the seller moved out and the buyers first saw the property after they had closed escrow and taken title, the property experienced a severe water leak (from a rupture in the refrigerator ice-maker line) that completely flooded a good portion of the home and created a serious mold issue. The remediation cost was in the tens of thousands of dollars, and litigation ensued because the insurance companies for both the seller and buyer refused coverage on the basis that no one could determine precisely when the damage occurred. Ultimately, the buyers’ insurance covered much of the out-of-pocket repair costs, but the matter wasn’t resolved for over two years, and the buyers didn’t have loss of rent coverage to make up for rent lost during that period.

The escrow officer or closing agent usually processes the mandatory reporting of the real estate transaction to the Internal Revenue Service and the state tax authorities, if required. If she doesn’t file the required 1099-S form, the brokers or the buyer and seller may be required to handle the reporting, which includes the identity of the property transferred, the sales price, and the Social Security numbers of the buyer and seller.

Be sure to keep a copy of the closing statement, because this document establishes your initial cost basis when you go to sell the property and need to determine your capital gain. Also, some of the expenses paid at the close of escrow may be deductible on your tax return, such as prepaid interest or points on your loan and property taxes and insurance.

Deed recording and property takeover

Although the escrow officer may have all of the signed documents, and funds have been transferred to the proper accounts, you aren’t the proud owner of your investment property until the deed is recorded. The procedure for recording the documents varies throughout the country but is becoming more standardized. Nearly every county utilizes a county recorder to record documents like real estate deeds, mortgages, deeds of trust, and other real estate documents as a public notice. Typically, there is an office of the county clerk and recorder, sometimes in the county courthouse in smaller jurisdictions.

Electronic document processing technology has made great strides in improving the efficiency in recording and retrieving documents at virtually all recorders’ offices. Now documents can be retrieved by computers in a matter of seconds and are usually indexed by grantor and grantee.

After you receive word that the deed has been recorded, the transaction is finalized; you’re the new owner, and you begin the property takeover process. There are several steps that you should take in the first few days of ownership, including

• Conducting a final walk-through and inspection of both the property’s exterior and interior to make sure that the property hasn’t been damaged prior to the close of escrow.
• Verifying that all items indicated on the personal property inventory list are present.
• Making sure that all keys were received (if the property is vacant, you should change the locks as an added precaution).
• Checking the utility meters to make sure that the utility company has switched the billing as of the close of escrow so you don’t get billed for the former owner’s usage.
• Meeting with tenants and assuring them that you’re a responsive and concerned property owner who wants to cooperatively resolve issues.

Another issue to address right after the closing is the possession and control by the former owner. Because the escrow closing and recording can often happen during the day without any specific notice, it’s best to wait until the following calendar day and personally verify that only the tenants that should be there are occupying the property. If the owner is still residing on the premises or is using some of the property for his own use, you need to immediately ask that he turn over full possession unless you’ve made other formal written arrangements in advance. To minimize this prospect, we suggest that you include significant daily monetary damages in the purchase contract for any unauthorized holdover usage by the seller.

Congratulations! You’re now ready to begin managing your property and increasing its value as you build the foundation of your real estate portfolio.