Notes, Mortgages, Operating Agreements, and Corporate Structure Q & A – Here’s What You Should Know

Want a fast tutorial on the basics of running a real estate investment company? Learn what the experts are saying.

There’s no time like the present to find out how the nation’s top real estate investment companies are being run. What’s the secret to their success? Leading professional investors and transactional real estate attorneys discuss some of the nuts and bolts of setting up winning corporations specifically designed to handle real estate transactions. They also cover other basics like notes and mortgages. Whether you already run your company at what you believe to be peak efficiency, or you’d like to find out what you can do to improve your operation, or even if you have yet to establish a corporate structure, here are some quick, basic insights, tips and Q & A with some of the nation’s top real estate professionals. What is an Operating Agreement? The Operating Agreement is the document that spells out how you’re going to run your company. For example, if you have two partners and one is the money person who’s going to fund the deals and the other is the person who’s going to find the deals, and they decide that each will have a 50% interest, that should all be clearly spelled out. The Operating Agreement should state who those members are and what their basic duties and responsibilities will be. Then, if there is ever a dispute down the road, you can fall back on the Operating Agreement. The Operating Agreement can be amended very easily, so as the business grows it can be changed to suit the latest business environment. It should be reviewed once a year to make sure it’s always current and accurate. Following are some key elements of the Operating Agreement:
  • Perhaps most importantly, when you need a loan for the business the Operating Agreement proves to the bank that you are properly operating your business. Banks will frequently ask for this document when you’re applying for a corporate loan.
  • It identifies the members of the corporation.
  • It spells out the duties and responsibilities of each member.
  • It indicates a level of professionalism and demonstrates you are organized, knowledgeable and serious about how you run your business.
  • It identifies the Managing Member and typically gives him the final say on how the business is to be run.
What is a Code of Regulations? A corporation is guided by a code of regulations, and the partners should mandate what that needs to say. There’s not as much flexibility with this document. The Code of Regulations indicates who has the most stock, and that person usually has the final say. Question and Answer Session with the Pros: Q: If you have an S Corp and you had profits last year in 2014, but you have not taken any draws throughout the year and didn’t take any salary throughout the year, how could you possibly deal with paying yourself a salary now that 2014 is over? A: You can do what is called a “Book Adjustment” and list it as a 2014 expense that gets paid out late. The IRS doesn’t care as long as you pay the proper tax on it. Q: If you’re going to use an LLC to hold properties, what do you recommend as the maximum value of the real estate you would hold in that one LLC before setting up another LLC? A: As a rule of thumb, you shouldn’t hold more than 4 or 5 single or two-family properties in one LLC. If you get to the point where you have more than 8 unit structures, apartment buildings with 8 units or more, etc., you should do one LLC for each building. But if you’re dealing with single family or two family units, you shouldn’t do more than 5. And you should also take into account vicinity. You can group them geographically. Theoretically there’s no limit, but it becomes an issue of liability. If you have 100 properties on one LLC, you have the potential for 100 cases of slip and fall. If you have a slip and fall in one property and they get a judgment, by law they can attach every property owned by that LLC, so it’s best to diversify the properties among LLCs. Q: Should my main investing LLC be separate from the brokerage LLC if the same 2 people are partners of both? A: It’s a good idea to have a separate LLC for each company that has a unique business model. For example, one LLC for a small group of rental houses and another LLC for your brokerage business. Do not get into a situation in which you have an LLC for acquiring properties and you have multiple funding partners in one LLC, which is a red flag to the SEC because they think you might be pooling funds, which is a separate deal that you’d have to register. You should never mix your funding partners together in one LLC. Each funding partner should be in his own LLC. Q: Since the LLC is a pass-through corporation, is it the same for a single person LLC as a multi-member LLC? Are they both pass-through? A: Yes. One is a sole proprietor pass-through and the other is a partnership pass-through. The income passes through to the LLC’s owner or owners. Q: What do you think about the Series LLC? A Master LLC with a number of smaller LLCs underneath it. A: It’s fine. It’s all about diversification of liability. Notes, Mortgages and Cross-Collateralization What is a Note? The note is your promise to repay. It’s the contract between the lender and the borrower and the instrument in which you acknowledge the fact that you owe the money. It identifies the borrower and the lender, the interest rate, and the payback terms. The note is your contract with the lender. If you default they can sue based on the note. They sue for breach of repayment of that note. What is a Mortgage? The mortgage is your security instrument. The mortgage should state that a lien is going to be attached to the property if there is non-payment of that loan. The mortgage is what is foreclosed on in the event of a default. If you don’t pay the money back then the lender will foreclose on the mortgage. They file an action that is two parts. The first is breach of the promissory note, indicating that you didn’t pay the money back, and the second is foreclosure of the mortgage which involves the court ordering the property be sold to repay the amount under the note. What is Cross-Collateralization? This is when you use one property to secure a note on another property. Say you own a rental property that is free and clear, that’s property A. And say you want to buy property B, which is a rehab. It’s a foreclosure that needs repairs. You could get a loan to fund property B, but a mortgage might be applied to property A, provided you agree. This is just the tip of the iceberg of what you need to know to run a successful real estate investing company. However, it does give you a bit of solid information that can serve as a foundation for helping you decide what kind of corporation to establish, what constitutes notes and mortgages, and the importance of creating an effective Operating Agreement.  
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