Forming an LLC is the preferred way for real estate investors to reap the tax advantages of an LLC and limit their personal liability on their property investments. An alternative option to an LLC is to increase your liability and umbrella insurance to protect your assets from malicious lawsuits and claims. Real estate investors can protect themselves by both forming an LLC and purchasing adequate
Thinking of forming an LLC (Limited Liability Company) for your rental investment properties? If you own or are planning to buy a rental investment, forming an LLC protects you and your assets in caase a legal case comes against your rentals. But it may not be the best choice for you.
Sometimes, the cost and maintenance that an LLC requires can be too troublesome, so increasing their insurance might be the better (and easier) option instead.
Weighing these pros and cons can help you make an informed decision to ensure you and your investment is protected.
Pros of Forming an LLC
One of the main reasons for forming an LLC is to limit your personal liability if something happens on your rental property. Consider this example: one of your tenants decides to throw a party, and one of their guests falls over a balcony ledge.
If the property is individually owned, there’s a potential that the injured guest might pursue a lawsuit. In that claim, the injured guest might name you, the owner, for providing an "unsafe condition" in the property. Your personal assets would not be protected, and you might find yourself defending your assets during the claim. But, if the property is owned by an LLC, you’d be protected by the company and the assets owned by the LLC would be exposed to the lawsuit instead.
Owners also enjoy the benefits of "pass-through" taxation under an LLC. "Pass-through" taxation means all the profits (and losses) of the LLC "pass through" the business to the LLC owners. The LLC owners then report this information on their personal tax returns. Simply put, the LLC does not pay any taxes itself, although it varies in each state if they impose an annual tax on LLCs. These taxes can get confusing, so consult your accountant to make sure you’re eligible for these benefits.
Another benefit of forming an LLC is that your name won’t be public knowledge as the LLC doesn’t need to include your name. Having a property with an anonymous owner protects your personal information from any number of scenarios, like prospective tenants from reaching out to you directly or criminals who want to use your personal information with malicious intent.
Cons of Forming an LLC
Set Up Costs
There are set up and maintenance costs to deal with when forming your LLC, which may or may not deter you from forming one. You pay a one-time filing fee to the state to form your LLC. There are also annual fees to ensure your LLC is in good standing. You might also have more fees related to tax preparation if you plan on having an accountant to handle all your taxes. These rental scenarios can get tricky and will likely need an expert to weigh in to make sure taxes are being filed correctly, so make sure your LLC is in good standing. These fees vary by state, so do your research before creating your entity to avoid any surprises.
Most lenders will likely refuse to finance a single/duplex/tri/quad family home as they want the owner of the property to be the person responsible for the mortgage, in case something goes awry. This means your LLC would likely only be able to qualify for a commercial loan. Which mean your LLC would need to show it could handle the loan – that is, the LLC would need to be able to show enough profits for next few years, the ability to pay back the mortgage, a positive credit history, etc. While you’re able to buy the property entirely in cash and then transfer the deed to an LLC, your lender might view this as a change in ownership.
If you transfer ownership without your lender’s permission, this might trigger the due-on-sale clause in your mortgage, which means the lender can demand the entire balance of your loan. This leaves you to either pay the rest off in cash, refinance your loan (which could prove to be difficult), or sell the property.
Confusion Around Asset Protection
There can be some confusion around what is actually covered under an LLC for rental property. The only real way to know what exactly you protected for under an LLC is when a lawsuit arises and uncovers the details of the agreement. An LLC Operating Agreement is a legal document that outlines your ownership duties of your LLC and can provide some clarity, but even then there still might be uncertainty around what will be protected.
What about Insurance?
An alternative to forming an LLC is increasing your liability insurance. You may still run into the same legal issues and your personal assets might still be at stake, but extra umbrella insurance will likely be able to cover most cases. Like an LLC, there are pros and cons that come with the decision to increase liability insurance to cover a rental property.
Pros of Increasing Insurance
It’s easier to give your broker a call to increase your liability and umbrella insurance than it is to go through the legal hoops of forming an LLC. You’ll have to get insurance to cover the property already, so it should be a fairly simple process to ensure everything is covered correctly.
An umbrella insurance policy can also be more straight-forward than setting up an LLC. Typically, one policy can cover several properties and only requires a phone call to add or remove any properties. Unlike an LLC where each entity is dictated by the state it was created in, an umbrella policy can also cover all properties in different states.
Umbrella insurance is extra liability insurance that protects your assets from major claims. It kicks in after you have exhausted all your other insurance policies. Luckily, umbrella insurance is usually reasonably affordable to add on to your typical insurance policy and usually comes out cheaper than your primary premium insurance costs.
Cons of Increasing Insurance
Potential Losses Beyond Your Property
The worst thing that can happen if a tenant sues your LLC-owned property is that you’d declare bankruptcy on your LLC and lose your property. In the case that you only have insurance to protect your assets, you potentially lose more than just your home. If your insurance policy doesn’t cover everything in the claim, you’ll have to cough up the rest of what you owe, and that may include other personal assets.
Nearly every insurance policy has exclusions, so if you aren’t careful you might find yourself caught in a tricky legal situation that isn’t covered. Always read the fine print and ask your broker if you need more clarification on any points that aren’t clear.
What Should I Do About My Properties?
Everyone has a different appetite for risk, so there’s no blanket answer that applies to each rental investment scenario. But there are certainly some best practices when considering what to do for your rental property. While the below may not be applicable to every setup, it may give you some ideas of how you should approach your rental properties.
Create an LLC for each of your properties.
The main drawback of many properties under one LL is that all the properties are at risk if there’s a lawsuit involving any one property. To mitigate this, create an LLC for each property you own so liabilities are separate if something happens to one property.
Create an LLC holding company.
Once you create an LLC holding company, each of the individual LLC-owned properties should up under the holding company. Also, this ensures that if a lawsuit arises, lawyers will not be able to "pierce the veil." Piercing the veil is a term that refers to courts holding shareholders personally responsible for the company’s actions or debts. The court might be able to reach your LLC, but this is when the anonymity of the LLC works to your favor and will personally protect you from a lawsuit.
Set up entities before purchasing your properties.
It is much easier to buy the property through the LLC to begin with, as opposed to trying to transfer the property to an entity. This saves the cost and effort of hiring lawyers to change over the ownership at a later date.
Set up an umbrella insurance policy.
A good umbrella insurance policy will help along with the LLCs and provide the best protection for your rental properties. You may find yourself evaluating your policies as time passes and as you take on more properties - it’s a good idea to do so to ensure you’re adequately protected.
Another important factor to consider is the type of property you own. A multi-unit or commercial property will have more liability exposure as it’ll likely have more tenants, so getting both an LLC and an umbrella policy might make the most sense. Yet, a single family rental in a decent neighborhood might find an LLC or an umbrella policy on its own perfectly enough. So, consider both an LLC and an umbrella policy in your research to make an informed decision so that you are protecting your assets in the most efficient and effective way as possible.
Equipping your rental investment properties with the correct protection requires a fair amount of research and preparation. It’ll take time to determine whether forming an LLC for your rental property is the right choice for you. While each option has its pros and cons, being well protected will help you rest easier knowing that your properties are being properly cared for.