Jordan Curnutt, CFP®
While there are many risks to becoming a real estate agent and, by extension, a small business owner, there lies a lucrative career path for those who can serve their clients at the highest level. Running any small business brings with it common and well-known financial pitfalls to avoid, but a few financial factors set successful real estate professionals apart specifically. Here are three financial planning mistakes Top Producing Real Estate Agents routinely make.
Sitting on Too Much Cash
The Problem: Trying to Solve the Variable Income Challenge by Sitting on Too Much Cash
One of the financial hurdles real estate agents must navigate is how to manage their variable income. On an intra-year basis, Top Producers must battle the uneven income stream of seasonality. The volume of transactions in the summer months can provide a significantly higher income potential than the lower volume months of winter.
That said, it is typically not ideal to base your ongoing lifestyle around the ebb and flow of the market. Instead, a steady, consistent cash flow is much more preferable.
On top of that, the market cycle of real estate as an asset class can also have a significant impact on a Top Producer’s income. When sales prices plummet (think the 2008-09 real estate and financial crisis), Top Producers must brace for longer periods of potentially lower income levels.
The strategy that we frequently see Top Producers employ to offset the risk that comes with variable income is to overweigh personal assets in cash. While having cash on hand is important and makes up the first step in a financially stable cash management plan, there comes the point at which having too much stagnant cash on hand inhibits the growth of your overall net worth.
The Solution: Implement a Personalized Cash Management Plan
The right cash management plan for you will adequately fund your lifestyle and provide a safety net to hedge against your variable income, while not sacrificing the growth of your net worth in the process. While each agent will ultimately need to decide what dollar value makes sense for each step of their personal cash management plan, below are some guidelines to get you thinking about what makes sense for your situation:
- Step 1—Spending Account
A good benchmark for your spending account (typically a checking account at your local bank or credit union) is two months of living expenses. You want this account to have a high enough balance that you are not always worried about a transaction clearing, while not over-allocating to an account that you are quite literally losing money on after inflation.
- Step 2—Emergency Fund
Our guideline for emergency funds for Top Producers is typically in the ballpark of an additional four months of living expenses. That said, the correct balance to maintain in an emergency fund is different for everyone, and your needs can even change over time as your circumstances change. Your emergency fund shouldn’t take any market risk since you may need to use it at a moment’s notice. Remember, emergencies are not planned!
We recommend utilizing a high-yield savings account for your emergency fund. This account type is the sweet spot between risk and return for emergency funds. While these accounts have FDIC insurance and do not fluctuate with the market, they typically earn more than five times the national average of traditional savings accounts.*
*Statistic quoted from Ally Bank: Earn more than 5x the national average. The national average for this type of account is 0.06% APY, based on rates published in the FDIC Weekly National Rates and Rate Caps accurate as of 5/3/2021. https://www.ally.com/bank/online-savings-account/
- Step 3—Brokerage Account
Your brokerage account is the third step in your cash management plan, and this step does not require a guideline as it is the pour-over for any discretionary savings once Steps 1 and 2 have been fully funded.
Your brokerage account is liquid and does not have any associated tax penalties for tapping the funds before retirement. Instead, this account type allows your net worth to grow according to the risk and return characteristics of the underlying positions you choose to invest in.
Since there is risk associated with this account type, we do not consider this as part of your emergency fund, but rather a backup to utilize in extreme emergencies or for funding your long-term financial goals.
Top Producer Tip: There are two more steps to our Cash Management Plan for Top Producing Real Estate Professionals, but they fall outside the focus of this article. To read more and learn about the last two steps, download our free guide here.
Failure to Diversify
The Problem: Overconcentration to a Single Asset Class
One of the biggest financial benefits that Top Producers have is their ability to identify and capitalize on an investment property. Since real estate is an illiquid asset, there are times when the market is inefficient, and as a result, a property can be purchased or developed at a fraction of its future value. Let us be clear: There is nothing wrong with leveraging your expertise when the right deal presents itself! That said, the problem arises when your net worth becomes overly concentrated in one single asset class.
While investment properties are the main source of this issue for Top Producers, the issue is not unique to the real estate industry. Consider tech employees in Silicon Valley who are awarded most of their compensation each year in the form of stock options. While one of the biggest financial benefits of working for the firm is the ability to capitalize on the appreciation of the stock, therein also lies a massive risk to their personal financial plan if the company struggles.
For the same reason it makes sense for tech employees to diversify out of their stock options, it makes sense for Top Producers to diversify out of their investment real estate.
So far, we have discussed the long-term risk to your financial plan by over-allocating to real estate as an asset class, but that risk is compounded when looking at the short term. Consider that the net worth of many Top Producers is wrapped up in not only real estate but also their personal income. Both are subject to variable and unpredictable market cycles of the same asset class. They leave the potential for a double-dip to your finances when they both struggle in tandem during the recession phase of the real estate market cycle.
The Solution: Bring Balance to Your Net Worth
Given your line of work, real estate has likely become a central theme in your personal finances. We advocate for a balanced net worth statement consisting of a variety of asset classes. That said, the goal is not to randomly pick a cryptocurrency here and an index fund there when looking to diversify your net worth. We consider two main factors when deliberately building out a Top Producer’s net worth statement: their financial goals and their financial values.
Financial goals: Your financial goals are the first conversation to have when identifying what investments make sense on each line item of your net worth statement.
The biggest driver to correctly match your financial goals to your investment selection is the time horizon. The sooner you need to utilize the asset in your financial plan, the less risk it makes sense to take with that investment. Inversely, the longer the time horizon you need to liquidate the investment, the more risk you can take.
Given your answer to the question “When will I need this money?” it is possible the right investment for you could range from a high-yield savings account, to a growth stock mutual fund in a brokerage account, to a bond fund in your Solo 401(k). Regardless of which investment option you pick, make sure you deliberately buy the investment with your time horizon in mind.
Financial values: The next screen to run your investment selection through is “Does this investment fit within my financial values?” Your financial values will be reflected in your answer to the question “What is the purpose of money to me?”
Depending on your response, your choice in diversifying your net worth could be taken in a variety of directions. Some of the answers we hear include “money creates stability,” “money is a tool,” or “money is flexibility.” Whatever money means to you, make sure that those values are reflected in your choice of investments.
Forgetting to Take Advantage of Available Tax Breaks
The Problem: Taxes!
When it comes to taxes, Top Producers are small business owners well acquainted with the reality that comes every April 15—and every quarter leading up to it, for that matter! Between federal, state, and self-employment taxes, the bill can add up quickly and eat into a meaningful portion of your take-home income.
In fact, let’s look at a case study:
Name: Top Producer
Filing status: Single
Schedule C income: $250,000
Estimated total tax liability: $99,849, or just shy of 40%
*Estimated tax projection generated in RightCapital financial planning software.
There is an adage that states only two things in life are certain: death and taxes. While we don’t disagree with this sentiment, we also know that just as a healthy lifestyle can positively impact your life expectancy, forward-looking tax planning can greatly benefit your tax liability.
The Solution: Forward-Looking Tax Planning
Tax planning is a piece to your financial plan that should be addressed more often than just every spring. We have found that most Top Producers are seasoned to the rhythm of paying taxes and are rarely caught off guard by a tax bill. But we have also noticed there routinely lies room for optimizing their tax bill with some forward-looking planning versus the backward approach commonly taken come Tax Day.
Remember, just as a car’s windshield is bigger than the rear-view mirror for a reason, tax planning can be even more important than tax reporting.
Here are a few simple tax planning tips Top Producers can implement throughout the year:
Contribute to a Health Savings Account
Health savings accounts (HSAs) are designed to facilitate savings for medical expenses. The best part about an HSA is that it allows for both a tax deduction in the year that you make the contribution and a tax-free distribution when you use the funds to pay for a qualified medical expense. The deadline for making an HSA contribution for a given tax year is the following April 15, which means you have some flexibility in the timing of the contribution.
Contribute to a Solo 401(k) or Other Retirement Account
While the correct retirement account to select can be different for each Top Producer’s personal situation, the Solo 401(k) is often a great option to consider. One of the most significant advantages to a Solo 401(k) is that the contribution limit goes all the way up to $58,000 for tax year 2021. Additionally, if you are age 50 or over, the annual limit is increased to $64,500 for 2021. The high contribution limits of the Solo 401(k) allow you the ability to build up a huge deduction against your earned income.
Plan Your Expenses Around Your High-Income Years
Every December, it is a good idea to take a look at your expected profit for the year and determine where you stand in comparison to your previous years’ earnings. Are you crushing it this year? Consider purchasing big-ticket business expense items in your highest income years when you will be in the higher tax brackets. Expenses such as computers, cellphones, cameras, and other big-ticket purchases have the most value as a deduction in the years that you make the most money.
Verify Your Choice of Business Entity Makes Sense
One of the bigger decisions for running your real estate business is selecting the entity type you wish to operate as. While most agents choose to operate as sole proprietors or LLCs while starting out, some circumstances may favor switching your business to function as an S corp.
Make sure to talk these options through with your financial planner and CPA to verify that the increased costs and complexity associated with operating an S corp are outweighed by the tax advantages.
Do Your Charitable Giving Tax Efficiently
While the intent to support a charity is always the driving force in donating, make sure that you evaluate all your options for giving when the opportunity presents itself. As tax law has changed over the years and the standard tax deduction continues to grow, planning for charitable giving has become key to getting any tax advantage at all for your gift.
A few strategies for giving that could make sense for your situation include gifting highly appreciated stock, “stacking” your charitable giving every other tax year by giving in January and December for annual gifts, or donating directly from your IRA accounts if you are over the age of 70 1/2. Be sure to consult your financial planner and tax advisor before selecting the best option for your situation.
Top Producers are uniquely positioned with extraordinary upside potential for wealth creation. But they also face a handful of financial pitfalls equally unique to their financial circumstances. The ability to successfully navigate challenges such as variable income, overconcentration to real estate in their net worth, and taxes can be a key indicator to their future financial success.
If you feel you could use the help of a financial planner who specializes in the needs of Top Producers, we encourage you to check out our process. The best way to start the conversation would be to schedule an insight meeting with our team to see if we are the right fit to help you optimize your financial future.