Short-Term Rental Mistakes to Avoid

One of the things that people always ask me when they're thinking of buying some property, some rental property, is should they put it in an LLC? And the first thing I tell them is, "Absolutely, you have to put it into an LLC," just for liability reasons, because people are sue-happy nowadays. You've gotta protect yourself and your personal assets. 

But what a lot of people don't realize is it takes two LLCs to totally protect yourself. The first LLC is basically a holding LLC. You either have that LLC buy the property, or if you already own the property, you have to transfer it over to the LLC so they actually hold the title or the deed to the real estate. 

it doesn't have anything to do with handling the guest communications, bookings or daily operations, or nothing like that. All it does is hold the deed.  You're isolating that part of it. Then you just need a second LLC that is the management part, and it actually operates the rental for you. 

It handles, it handles all the heavy lifting. It, it signs the contracts, if you're advertising it with, Airbnb or VRBO or anything like that, newspapers, wherever you advertise it. it holds all your business licenses. It pays for the insurance. It hires the cleaning companies, everything needed to take care of that rental. 

Transcript

Short-Term Rental Mistakes to Avoid 
 

Roger: In the last few episodes, we've talked about different types of businesses that you can get into. We had a session that discussed the evils of multi-level marketing, and there are alternatives to that that are actually legit. We've talked about franchising and what you need to know if you're thinking about going into that area of business. 

But today, I wanna talk about something that's become more popular recently, and that's the subject of short-term rentals. So let's get started. 

Announcer: You are listening to the Mastering Business Basics podcast, where we discuss how to build a solid foundation under your small business to improve your chances of success. And now, here is your host, Roger Pearson. 

 Roger: One of the things that people always ask me when they're thinking of buying some property, some rental property, is should they put it in an LLC? And the first thing I tell them is, "Absolutely, you have to put it into an LLC," just for liability reasons, because people are sue-happy nowadays. You've gotta protect yourself and your personal assets. 

But what a lot of people don't realize is it takes two LLCs to totally protect yourself. All right? The first LLC is basically a holding LLC. You either have that LLC buy the property, or if you already own the property, you have to transfer it over to the LLC so they actually hold the title or the deed to the real estate. 

it doesn't have anything to do with handling the guest communications, bookings or daily operations, or nothing like that. All it does is hold the deed. All right? You're isolating that part of it. Then you just need a second LLC that is the management part, and it actually operates the rental for you. 

It handles, it handles all the heavy lifting. It, it signs the contracts, if you're advertising it with, Airbnb or VRBO or anything like that, newspapers, wherever you advertise it. it holds all your business licenses. It pays for the insurance. It hires the cleaning companies, everything needed to take care of that rental. 

And you have to have an arm's length lease. So basically, the holding LLC leases the property to the management LLC, but it has to be at market rate. What otherwise, if you were hiring another management company, what you would pay them to management for you, that's what you have to do. You just can't go, "Okay, since I own both of them, I'll just make it real cheap." 

You can't do that. And by doing it this way, it creates a firewall. So if a guest sues you for a slip and fall, they're suing the operator, which is the management LLC, not the property owner, which is the holding LLC. This is what you have to do to protect yourself. 

And if you set it up this way, they can't come after any personal assets, and too many people make this mistake. Now, if you're hiring a management company, then you don't need the second LLC yourself because that management company you're hiring is its own LLC. 

You hire the management LLC. So that's the difference between hiring a property manager and managing it yourself. If you're gonna manage it yourself, you've got to create that management LLC the same way as if you hired someone else to do it. So that's the first thing that you really have to take into consideration if you're gonna go into the property rental business. 

The second thing you need to take into consideration is how you wanna handle the profits or losses on your tax returns, because there's two ways to do this. The majority of people just use it as passive income, and a small minority will do active income. So what's the difference? Well, passive income basically means that Your losses cannot be taken against your other income on your taxes. 

It has to be rolled over. Any losses have to be rolled over until a year in which you do have profits that you can deduct it against. You never lose them, you just have to keep rolling them over until such time as you can deduct them against profits. The other way is active income. Now, active income you can deduct against other income on your taxes. 

However, there's a caveat here, and there's two things to consider. The first one is you have to have something called material participation, and that means that you have to spend, so many hours a year managing the property yourself. Otherwise, doing maintenance or calling maintenance people to come do it, or, cleaning it yourself or hiring people, going back and forth to check on it. 

Whatever it takes to run that business, you do yourself. And generally, I think it's about seven hundred and fifty hours a year that you have to spend on it to be able to, claim that, "Okay, I actively participated in it." You know? Just like if you owned a motel or something, 

You know, if you've got a maid service, you put out the little soaps, whatever it takes, to run that motel. It's the same type of thing, except on of course, a smaller scale because it's just the one property that you're managing, or multiple properties you can do it over. So that's the thing you have to consider. 

Now, as far as taxes goes, if you can prove material participation, you need to keep a log of everything you do. You need to keep mileage logs. You need to keep expense logs. You need to, to put how much time that you did it, because you have to be able to prove to the IRS that you spent that number of hours during the year taking care of your properties. 

So, and there's a lot of, nice tools out there. MileIQ, for instance, can keep track of your mileage automatically. There's a lot of different ones there  where you can hit start and stop, and it figures out the mileage for you. the thing about it is, then you can take, if you have a loss, you can deduct it against your other income, like your W-2 income. 

Here's the caveat to that, though. If you have a profit, then you're subject to the 15.3% self-employment tax, which is your Medicare and your Social Security taxes. So you have to pay that. So on one hand, if you have losses, you can deduct against your other income coming in the household. 

But if you have profits, you're gonna end up paying more in taxes. So there's a trade-off. Now, there's ways to get around that by incorporating and things like that. But for the discussion we're gonna have today, we're gonna make it simple. We'll just say sole proprietorship, you know, single-member LLCs, or even multi-member LLCs. 

They are subject to a 15.3% self-employment tax. But if you're running losses, then you can deduct it. So that's up to you which way you wanna go. 

So now that you know a little bit about the legal ramifications of short-term rentals, and the tax consequences of how you run your business, there's really three different ways that you can get down to the day-to-day. All right? And of course, the first one is self-management. Self-management is usually good for like local owners that have a high tolerance for urgency, because you could get called in the middle of the night to come fix something Basically, you're the manager, you're the cleaner scheduler, you're the plumber caller, and you're the guest support rep. 

But if you're gonna do something like this, you need to use, i- what's known as a channel manager like, OwnerRez or Guesty to combine all of your booking calendars. Because if you don't automate this stuff, you're gonna eventually double book and suffer the consequences. This is what hiring a management company does for you. 

They do all of this stuff. But you're responsible for it, so you're gonna have to learn how to do the entire booking and everything also, all right, in addition to all the maintenance. 

Then there's the hybrid method, which has got a little bit of both. And this is usually, best for busy professionals who want expert marketing but they wanna keep control of the property maintenance costs themselves. 

So your core task is basically you outsource the listing optimization, pricing, and guest inquiries to, companies out there like Airbnb. these are advertising and marketing firms, and that's all they do. They find the people for you. They find the renters. you hire that part out, but then you keep direct management of the boots on the ground stuff, the cleaners, the handymen, the landscapers, everything else, okay? 

So you need to be, excellent at managing your local vendors, and your phone will still ring if the cleaner cancels with only a two-hour window before a check-in, you gotta go deal with it. 

Then you have the full service which is best for people that just are investors with properties in other cities or those who want zero involvement. 

They just want the P&L at the end of the year, and they deal with that. So you pay generally between twenty and thirty-five percent for a concierge level hands-off experience. You have to be able to ask yourself is this how much I wanna be able to give up? Is this how much of expense I wanna pay for not having to deal with it. 

And actually, a lot of people, they actually do that. I think the majority of people that I've done taxes for real estate actually just hire a management company rather than do it themselves, and then I get the statement from the management company end of the year. but here's the thing about this. Never blindly sign a management contract. 

You have to insist on a price floor clause, and that means you need a minimum nightly rate below which they cannot drop the price to assure occupancy. Because you just don't want them just putting anybody in there, and messing with the prices. You have to protect your asset's value, from their desire for easy volume because, hey, they're getting a percentage no matter what. 

So you need to make sure that clause is in any management agreement. "I want this so much, and this is a minimum I want to rent this out for a night. Okay. Can you do that?" If not, maybe you should find a different management company. So make sure you have that 

You have to consider that What is your risk mitigation? Okay. And what about client or guest screening? A vacation rental is basically a hotel that's set in a residential area. You have to think of it that way. And so you need to manage your guest behavior proactively. For instance, you have to consider the neighborhood the rental is in, and you can use, technology. 

Technology is great when it comes to this. There's, software like NoiseAware, where you can monitor decibel levels in the house, and this protects the neighbors, and it alerts you instantly if a party starts, allowing you to intervene before the police are called. You don't wanna have to deal with that. So use technology. 

You have to consider insurance. Remember, standard homeowners insurance will not cover guest accidents. So you have to have a specialty STR policy that includes loss of business income. And so if your home is damaged and needs months of repair, this policy keeps your cash flow alive, While you're getting it taken care of. That you need to take into consideration. 

The next thing you need to consider is operational excellence, and some people would call it the five-star standard, okay? Your rating on these sites is your currency. If your rating drops below 4.5, your income's gonna collapse because the platforms will hide your listing. 

Oh, yes. they wanna put the five stars out front because that's their bread and butter. That's where they make their money. And so the first thing is, the cleaning crew is more important than your property manager. You have to hire the one who sends you photos of the rooms after they're turned. 

A consistently clean home is actually the number one predictor of revenue... of reviews, and reviews are your bread and butter. You need to use smart technology. invest in some smart locks. Yale and Schlage m- makes them. They generate unique codes for every guest, and that makes it both secure and creates a frictionless check-in. 

You just give them, "Here's your number" boom, and, it lets them in. You're not having to go worry about changing keys or anything like that, and once they're gone, that code disappears, and they can't get back in. You want that type of security on your property. 

And you also have to consider municipality risk. Before buying, you need to check the local zoning laws. There's, there are some cities that are now placing cap limits on how many properties can be rented. Always ensure that you're on the right side of the law to avoid being shut down by a city ordinance change. And I know that because, right now, my HOA is having a argument between the property owners, there's about, oh, three hundred and fifty, properties in this HOA, and whether to forbid renting out, the houses here because renters tend to not take as good a care of things. 

And, so there's some problems when it comes to that. That, argument is going on probably all across the country. So you need to check to see if there's anything that prevents you from doing this on the particular property you're looking at buying also. that's very important. 

And finally, you have to consider the financial aspects, the overall financial aspects of this, And a lot of people get into this business, and they wonder why they aren't rich. the answer is usually revenue versus profit. so you have to take your gross revenues, you have to subtract your platform fees, you have to subtract your management fees, you have to subtract your cleaning and vetting fees, your insurance fees, your taxes, your maintenance, your time before you get to your net profit. 

if you spend twenty hours a month fixing issues for a profit of five hundred dollars, then your hourly rate is twenty-five dollars an hour. If you could be working at your career or investing that time elsewhere at a hundred dollars an hour, then you're losing money by self-managing the property yourself. 

And that's an analysis that you really need to take when it comes down to the end is, "Okay, do I really wanna get into this business? And if I do, do I wanna manage myself? do I have the time to do that?" Some people, they view that as more of a retirement type, income they're building over their lives. So you may wanna look at it that way also,. 

The other thing is you need to look at it in the scope of your entire life. is this something that you wanna make money in now to live on, or is this something that you're investing in for your retirement? And a lot of people, I have a lot of clients, they're gradually investing in multiple, rental properties, and that's how they plan to retire. 

Because, they're the self-employed type people. They don't have huge 401Ks that they've worked, 25 years at a company trying to build up. But I tell you, If you have a dozen different rental properties, and you're good at it, and you're comfortable with it, and you're willing to put up with the nonsense that they create, then you can build yourself a nice income that'll last you in retirement. 

But that's what you have to base it on. You can't base it on just greed You need to secure your foundation. You need to talk to a CPA or a tax professional about the holding management LLC structures and get that right at the very beginning. Then you have to build your team, even the best self-managers need a backup cleaning crew or on speed dial if the one says, "Oh, we suddenly can't..." 

and that happens. So don't just depend on one, handyman or one cleaning crew or anything else. Always have somebody in backup that'll cover your butt if you need them, okay, at any time of the day or night. And you have to stay compliant. regulations change, HOA requirements change, city requirements change, and you have to have permits for all this stuff usually. 

So you need to review those permit requirements annually and make sure you're on top of them. That's your responsibility. That's not your management company's responsibility. So if I were to give any final advice about this, I'd say the most successful hosts are those who treat the guest with genuine care, treat their property with professional respect, and treat their finances with IRS-level rigor. 

If you build it right, it really will be a true asset for years to come. If you have any other questions about this subject, please go out to my website, seagulltechnologies.com , and just click Contact and let me know and i'll be glad to cover it in a future episode. In the meantime, thank you for listening, and we'll see you again. 

Announcer:  You have been listening to the Mastering Business Basics podcast with your host, Roger Pearson. For more information about all of the business education options that are available, we invite you to visit seagulltechnologies.com and continue your journey.