Being a realtor is not for the faint of heart. The fluctuations in your income from year to year based on housing market ups and downs can make financial planning extremely challenging. Here are some tips on managing your finances through the real estate cycles:
Handling the Boom Years
There’s nothing quite like a hot housing market to send a realtor’s income into the stratosphere. When the sales are flowing, you may find yourself being bumped into a higher tax bracket than you’re used to. While celebrating the increased earnings, it’s also crucial to plan ahead for paying those higher taxes. Making quarterly estimated tax payments is wise to avoid stinging underpayment penalties later. The IRS doesn’t care that your income is temporary – they want their cut!
It’s also a great time in the boom years to bulk up your retirement accounts and investment accounts for the leaner times ahead. Contributing to tax-advantaged retirement plans like 401(k)s and IRAs not only builds your nest egg but reduces your taxable income as well. You may even want to explore contributing to a cash balance pension plan which allows very large tax-deferred contributions.
Weathering the Lean Times
Housing markets are cyclical, and inevitably you’ll go through periods where sales screech to a halt and listings dry up. This unpredictable income creates stress around budgeting and paying basic living expenses. It’s important to build up a cash reserve during the good times that can carry you through a year or two of leaner earnings. Experts recommend socking away enough to cover 6-12 months of living expenses as a baseline emergency fund.
When income is down, look for ways to reduce your estimated tax payments. Filing taxes quarterly when your income is variable prevents you from overpaying the IRS with each paycheck. During market slumps, make sure you are taking advantage of all eligible deductions and tax credits like the 20% qualified business income deduction for pass-through entities.
To Incorporate or Not?
As a realtor, you have the option to operate as a sole proprietor, LLC, S-Corporation or C-Corporation. There are pros and cons to each structure in terms of taxation and legal liability protection. The ability to take the 20% qualified business income deduction for pass-through entities makes operating as an LLC, partnership or S-Corp very appealing from a tax standpoint.
Many realtors start out as a sole prop while building their book of business, then choose to incorporate or form an LLC once they have established a solid income stream. If you’ll be hiring employees or want to maximize legal protection, an LLC or corporation makes more sense.
If structuring as an S-Corp, it’s critical to pay yourself a reasonable salary from the corporation and take the remaining profits as distributions. This allows you to avoid paying payroll taxes on the entire net income. However, there are compliance requirements to maintain an S-Corp that add some accounting overhead.
What to Focus on as a New Realtor
In your first few years in real estate, your biggest challenges financially will likely revolve around inconsistent income and cash flow. Don’t be lured into an extravagant spending pattern just because you have a few great sales months. Revenue and expenses rarely happen in tandem, so budgeting for the long-term average is important. You may want to start out as a sole proprietor when first getting licensed to keep things simple while testing the waters.
As your business grows, meet with an accountant experienced in working with realtors. They can make recommendations on your entity structure, allowable tax deductions for things like marketing, licenses, car expenses, and help you start building up retirement funds. With proper tax planning and budgeting systems in place, you’ll be able to roll with the inevitable real estate market cycles.
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