Why Forming an Entity to Protect Your Private Wealth From Your Investment Property Liabilities is Critical in Today’s Litigious Real Estate Environment
Do you believe that an investment or rental property insurance policy is enough protection for you and your personal wealth in the event of an accident or other catastrophe to your tenants? If you are not sure or have not even thought about this then its time – right now. The parade of horribles that can occur which could result in a serious injury, a permanently paralyzed tenant, or a wrongful death is not that far-fetched.
The typical landlord insurance policy has burning limits which probably wouldn’t cover the total of all of the liabilities you could be responsible for. One way to protect your assets, your personal home, and your personal income from liabilities from investment properties is to legally place the property into a separate entity which shields you from litigation exposure. Most competent attorneys and financial planners recommend each property have its own separate entity such to help prevent one bad event from destroying all of the other assets. Please read below for some practical strategies and techniques which may shed some light on this issue for you.
Limited Liability Companies (LLCs) Are The Preferred Method Of Entity
Most people choose an LLC in order to protect personal assets – transferring the ownership of investment real estate and other assets to an LLC shields liability from an aggressive plaintiff’s lawyers attacks. In the event an injury or catastrophe occurred that was held to be the landlord’s responsibility the landlord’s insurance policy would take over for compensation and litigation defense. If the injury compensation required was greater than the amount of the insurance policy the injured tenant could seek redress from the asset itself, i.e., the equity in the property. If the compensation awarded by the arbitrator or jury exceeded the amount of insurance and equity in the property then the injured tenant would seek the personal assets of the landlord. This is where the properly formed and run LLC protects the landlord. The outer shell of the LLC, so to speak, is the limit of monetary exposure of which the injured tenant could attack. Without this protection the injured tenant could seek compensation from any asset or source of income that the landlord had save for retirement income streams which are statutorily protected.
An LLC is somewhat similar to a partnership but has the formal legal protections for personal & real estate investing assets that a corporation offers without the formalities, ongoing paperwork and annual fees. The exact rules for forming an LLC vary by state, but in California there is an $800 per annum filing fee to keep the LLC in good standing. Moreover, it is paramount that the LLC be properly formed, and that annual meetings and procedural safeguards are maintained. For example, the LLC can’t be a sham to avoid liability – it must abide by the rules of the state of formation.
Almost all personal and investment real estate, including primary residences, rental and investment properties, and vacation homes can be included as assets in an LLC. If properly formed and allocated this possibly can allow all residences and any type of real estate to be protected from seizure. Importantly, an LLC can be a single member LLC asset, with a single owner, and still be considered a valid asset shelter. If a real estate loan is required, the LLC may be eligible for special loan terms, but more than likely there are special rules which must be abided by if transferring a property already encumbered into an LLC. Check with your loan documents or loan broker for the requirements.
A lawyer is not required to set up an LLC since state requirements are usually fairly simple. However I would never recommend anyone doing it on their own since it is such an important process in protecting your real estate portfolio. Your operating agreement, your procedures, and your filing are all very important so please make sure your interests are protected and hire a competent attorney to help you.
There Is Added Privacy Inherent In LLCs
Ownership of an LLC is difficult to track and locate for most members of the public but this won’t provide complete privacy. Owners of LLCs will be found in the event of a lawsuit, but this added layer of privacy will prevent some nuisance contact and provides a much desired minimum level of anonymity.
LLC’s Can’t Be Used Like Personal Piggybanks
If an action is filed against your LLC, the property or other assets in the LLC can be seized if a judgment is entered. Additionally a lien could be placed against the LLC, which can cause disruptions. Importantly personal expenses like haircuts and shopping sprees cannot be paid by the LLC directly. The LLC must distribute the income in an orderly and consistent manner. If it does not then the LLC can lose its limited liability status and will become a legal nullity. A plaintiff’s attorney could argue that paying personal expenses makes the LLC invalid and that the member illegally transferred assets to the LLC as a sham – it’s a form of ‘piercing of the corporate veil.” Thus, its important to follow the rules.
LLC’s Taxation Is a Pass-Thru Entity Just As If the Income Were Personal
LLCs are treated as pass-through tax entities similar to sole proprietorships and partnerships – so there is only one-layer of tax. Unlike an S- or C- corporation, which required double taxation and must file tax returns separate from an individual’s income tax, the LLC is only taxed a one level.
In California the filing process is fairly simple. You will need a few basic details about your LLC, such as its name and address, and contact information for a person involved with the LLC (usually called a “registered agent”) who will receive legal papers on its behalf. You will need to file Articles of Organization, an Operating Agreement, and Charging Papers. The operating agreement is an important document because it sets out the LLC members’ rights and responsibilities, their percentage interests in the business, and their share of the profits.
Protect Yourself, Your Family And Your Future
If you own investment property, or other assets which are exposed to potential liability an LLC is something that you should consider right now. This is especially important if your investment property is being managed by a professional property manager wherein you don’t have any day-to-day knowledge of the property or activities. Without doing anything you are potentially exposing that asset and all of your personal assets to litigation. Do the right thing and look into this process right away. If you have questions please don’t hesitate to contact me.