Financial Planning Guide for Real Estate Agents
Real estate agents and brokers often own businesses or are not traditional “employees.” Owning a business or acting as an independent contractor brings the opportunity and responsibility of making their own decisions.
While some decisions can be made with little thought, like blocking off an afternoon to watch their child’s soccer game, some decisions are not so straightforward. Some of the more difficult decisions tend to involve personal financial planning topics.
The skills of a real estate professional involve educating, effectively communicating, and solving problems for others. They fill this role for their clients, but do they have someone doing the same for them and their financial future? “Financial planning” certainly isn’t included in their job description, but real estate professionals need more financial guidance than most.
Irregular Income
Real estate professionals can experience rather large income fluctuations throughout their careers, with significant incomes during hot markets and more limited incomes during cool-down periods. Some will be tempted to splurge when their income is higher and might be tempted to dip into savings when the cash flow has dropped. Establishing a solid cash buffer can alleviate fluctuating income and resulting tax bill changes while allowing them to stay invested for long-term objectives.
With the typical real estate bear market averaging about two to three years, real estate professionals should keep about six to twelve months of liquid funds as a buffer. Although their entire income doesn’t need to be covered for two to three years, they must supplement the lost income. This buffer typically consists of cash or conservative fixed-income investments.
Business Structure
Real estate professionals must also decide on an operation business structure. Jonas LaGrew, a Certified Public Accountant and Partner at Apex Business Consulting, a North Carolina-based tax accounting firm specializing in serving real estate professionals, says that real estate professionals tend to start with a Limited Liability Company (LLC) and elect to be taxed as a Sole-Proprietorship or Partnership. As income increases, some will graduate to tax their LLC as an S-Corporation (S-Corp). The significant advantage of an S-Corp lies in taxation. Sole-proprietorships and Partnerships are responsible for paying ordinary income tax and self-employment tax on all income as wages. S-Corps can elect to take a portion of income as distributions rather than wages. The distribution portion of the income from an S-Corp is taxed as ordinary income, but a self-employment tax is not applied. The self-employment tax is intended to fund future Social Security and Medicare benefits for the business owner. When deciding their compensation structure, younger self-employed professionals must ask themselves whether they believe Social Security and Medicare benefits will be available when they retire.
Benefits
Since most real estate professionals are self-employed, they don’t have access to typical employer-sponsored benefits, meaning they must determine everything from their insurance to time off.
If they have an employed spouse, their family might have health and life insurance benefits offered through the spouse’s employer. Many employers will also offer a Health Savings Account (HSA) to accompany a high-deductible health insurance plan (HDHP). The HSA is a tax-efficient tool for health needs because the contributions are tax-deductible, the growth is tax-free, and the withdrawals for qualifying health expenses are also tax-free. High-income earning real estate professionals with expected future health needs and a high deductible health insurance plan should explore the opportunity of opening an HSA.
Now for the bad news. While the spouse might have a short-term and long-term disability policy through their employer, it likely will not cover the real estate professional. Real estate professionals might be able to utilize the benefits offered by the National Association of Realtors, which provides members access to health, vision, dental, life, and even pet insurance but doesn’t provide access to disability insurance. Disability insurance coverage is often one of real estate professionals' most significant protection shortfalls. While many are underinsured, others lack any disability insurance coverage at all. Real Estate professionals’ probability of needing disability insurance typically results in higher premiums than are charged to other professionals.
As a rule of thumb, young real estate professionals with families should carry about ten times their annual average income in total term life insurance coverage. “Term” means that the coverage has an expiration date. Term lengths are typically 20-30 years, knowing that not as much insurance is needed once children are grown and mortgage balances are paid down. Term policies are typically the least expensive type of life insurance, allowing the policy owner to invest more money than they would if they opted for a policy with a higher premium.
Time off is critical to any family’s mental and physical health. Whether it be that afternoon soccer game or an extended vacation, both costs and opportunity costs affect long-term financial objectives. A financial planner can quantify the effects of various lifestyle decisions on the professional’s personal financial goals.
Retirement Plans
One of the significant disadvantages of being a real estate professional is that they likely don’t have access to an employer-sponsored retirement plan, like a 401(k). But I have good news; this can also be advantageous. Real estate professionals could potentially contribute more tax-deferred retirement savings than their corporate counterparts. The trick is all in selecting the best retirement plan option for them, their family, and their business. The SEP IRA, SIMPLE IRA, and SOLO-401(k) are real estate professionals' most utilized retirement plans. Each plan has pros and cons depending on the professional’s income and company demographics, such as the number of W2 employees and years of tenure. This is essential because the real estate professional is considered the “employer” under these plans. These retirement plans can be a powerful tool in reducing the professional’s taxable income in hot real estate market years. Contributions to these accounts reduce the real estate professional’s taxable earned income dollar for dollar in that tax year.
Many real estate professionals are career changers and might have an employer-sponsored retirement plan through their previous job. While they are no longer eligible to contribute new dollars to that retirement plan, they can often roll those funds over into a new plan or a new account. This should be considered to ensure the investments suit their investment objectives.
Investments
I firmly believe in real estate investing. We own our home and office building and know that real estate can generate solid returns while creating tax advantages.
Real estate professionals tend to place a significant portion of their total net worth in real estate investments. While this can be an effective strategy if well executed, the investor is exposing themself to considerable market and liquidity risk. With their income and investment returns both tied to the real estate market, some diversification can often be advantageous. Diversifying into an employer-sponsored retirement plan and other investment accounts will allow them to participate in other asset classes that might not directly correlate with the returns of the real estate market. Diversification is a popular strategy investors use to protect their hard-earned wealth from significant fluctuations in value. Liquidity risk involves not having immediate access to cash when it is needed. Accessible money is required to meet liquidity needs due to a reduced income in a down real estate market or money required to capitalize on an investment opportunity.
Other asset classes include stocks, bonds, commodities, and other alternatives. Real estate investment can also be achieved through direct ownership opportunities in passive real estate investments without the obligation to personally manage real estate property rentals, leases, or maintenance. One consideration when investing in various asset classes is that some might generate additional taxable income in the current year. This could result in adverse tax consequences for the professional, potentially placing them in a higher tax bracket. As a result, “Exchange Traded Funds” (ETFs) have increased in popularity as a tax-efficient structure that can help mitigate an investor’s tax exposure.
In addition to these more conventional investment options, real estate professionals could have the opportunity of owning their businesses. Building, growing, and selling a company for a valuation multiple of the annual earnings is an effective way to generate a strong return.
Tax Strategy for Retirement Accounts
Consider the real estate market cool-down periods we discussed earlier, where real estate professionals would experience a reduced income. This often puts the real estate professional in a lower income tax bracket and reduces their income tax rate for that year. For example, a single real estate professional earning $171,000 in 2022 would be in the 32% federal tax bracket, while a reduction in income to $170,000 in the same year would place her in the 24% federal tax bracket.
A Roth Conversion is a powerful tax strategy in years of reduced income. A Roth conversion is switching pre-tax money saved for retirement, such as in the retirement plans discussion above, to an after-tax Roth account. Real estate professionals can strategically recognize taxes in years they are in a lower income tax bracket, thus keeping more of their saved money due to paying less in taxes over the years. Once funds are converted to a Roth account, they are never taxed again. This strategy is incredibly impactful for real estate professionals due to fluctuating incomes.
Consider another example with the single real estate professional. If her regular income of $171,000 dropped to $130,000 in 2022, she could convert $40,000 of her pre-tax retirement money to a Roth account. Rather than paying her usual tax rate of 32% on this converted money, resulting in $12,800 of additional taxes due to the transaction, she would only pay a 24% tax rate due to her reduced income placing her in a lower tax bracket. The tax hit on this Roth conversion would now be $9,6000, saving her $3,200 in taxes and allowing these funds to grow and be withdrawn tax-free for the rest of her life.
To perform a Roth conversion, the real estate professional must, at minimum, open a Roth IRA. Depending on the type of employer-sponsored retirement plan the real estate professional implemented for their tax-deferred retirement savings, they might also need to open a Traditional IRA as a “stepping-stone” to perform the Roth conversion. It is a good idea to open both the Roth IRA and Traditional IRA regardless of the Roth conversion tax strategy, as employer-sponsored retirement plans will often allow for contributions to both the retirement plan and IRAs in the same tax year.
Tax Strategy for Family Business
Self-employed real estate professionals make the decision of who they hire, which can include their minor children. Consider a family, with two minor children, in the 35% tax bracket due to a household income of $470,000 in 2023. If the professional were to include their children on the payroll for annual compensation of up to $13,850 per child, this would effectively shift the income from the professional’s 35% tax bracket to the child’s 0% tax bracket due to the $13,850 standard deduction in 2023. This would reduce the family’s tax burden by $9,695 ($13,850 compensation per child x 2 children x 35% tax) in year one.
The minor children’s earned income can then be used to fund an investment account. A Roth IRA is a popular account type for children with earned income because the balance can be grown and withdrawn tax-free with the ability to use the funds for education, retirement, or a first-time home purchase.
Each taxpayer is permitted to gift up to $17,000 to as many recipients as they wish in 2023 without owing gift tax or reporting the gift on either taxpayer’s tax return. This gift exclusion covers gifts to anyone, including parents. You will notice that the gift exclusion amount of $17,000 is greater than the child’s compensation of $13,850 in this example.
Tax Deductions
Tax deductions can be used to reduce one’s taxable income and, as a result, lower the tax rate used to calculate the tax due. Real estate professionals who are business owners or independent contractors can take advantage of deducting their business expenses. Some common deductions include marketing and advertising, a home office, commissions paid, business tools, and software. Professionals might even utilize bookkeeping software to log their business expenses as they are accrued automatically.
At the end of the year, once all business expenses are totaled, the decision must be made to deduct either the “standard deduction” of $13,850 for individuals in 2023 or their deductible business expenses. If the sum of deductible business expenses exceeds the standard deduction amount, the business expenses will typically be chosen to deduct against their taxable income.
Debt
Many real estate professionals have obtained higher education, often with student loans. Student loans can cause significant stress to an already stressful career, especially when the average student loan interest rate has historically been 5.8%. Some professionals will feel compelled to repay this debt as quickly as possible, but like most things, addressing debt versus investing is all about balance.
When deciding which debt to pay back first, it will result in the lowest total interest payments if the highest interest rate loans are paid down first. Once they’ve decided which loan to direct excess cash flow toward, the optimal way to address debt repayment is to place extra money where it will provide the greatest return. For example, if an investment is expected to return 7%, and the loan is at the average 5.8% interest rate, you would be better off paying the minimal amount toward the loan and investing the rest for a 1.2% net return outcome (7.0 – 5.8 = +1.2%). On the other hand, if an investment is only expected to return 5%, the professional could lose 0.8% by not directing funds toward the loan (5.0 - 5.8 = -0.8%). A Financial Advisor can help determine long-term averages and current market expectations.
Business owners and independent contractors face a more challenging approval process when applying for a mortgage due to their lack of a W2 displaying steady income. Like with their home buyers, the first step is to get pre-approved. Then there are alternate approval methods and other mortgage options for business owners and independent contractors. One alternative is a bank statement loan, which is harder to find but is intended to help business owners and independent contractors with fluctuating incomes who have difficulty meeting the standard income verification requirements. An alternative is to use a payroll provider to pay themself a salary on a W2. This strategy typically goes hand-in-hand with the S-Corp tax structure, as payroll is needed to distinguish between salary and distribution income from the S-Corp.
Protection
Being a business owner exposes real estate professionals to additional risks, such as injuring others due to a car wreck while working. Personal auto policies might not cover liabilities that occur while on the job, so real estate professionals whose job involves time behind the wheel should review their policy to confirm they are covered. All business owners should also consider purchasing an Umbrella insurance policy that covers professional liability. Umbrella insurance policies stack on top of existing liability policies, covering any claims that exceed the insurance limits of the existing liability policy. This becomes especially important if a professional’s assets are valued at more than the current liability limits. Most auto insurance liability limits are $100,000 per person (often capped at $300,000 total for a group) and $100,000 for property damage. Most Umbrella policies will provide an additional $1,000,000 of liability coverage on top of the existing liability limits and cost an average of $150-300 annually.
Choosing a Financial Advisor
If this seems like a lot, it is! That’s why Financial Planners have a role and why, like real estate professionals specializing in Residential or Commercial properties or as Buyer’s or Seller’s agents, Financial Advisors specialize in working with a specific clientele.
