Owning rental properties is a great way to build wealth. If your renewal income covers monthly expenses you’ll generate predictable cash flow. You can easily and safely use leverage to turn appreciation of a few percent a year into double-digit gains. Finally, you can take depreciation of your rentals on your taxes – this allows you to show a tax loss even though you’re cash flow positive. This tax loss offsets your rental income, which means you typically pay little to no taxes for at least the first few years of owning a property
However, real estate investing is not all unicorns and rainbows. There are many potential downsides – dealing with vacancies, problematic tenants, maintenance expenses, and the proverbial call in the middle of the night to fix an overflowing toilet.
In my opinion, the single biggest risk of real estate is opening yourself up to potential liability. If somebody is injured (or worse) on your property due to negligence you could be held personally liable. All of your assets could be at risk. The tenant can sue you and, if the judgement is large enough, come after your house, car, and any other assets or investments you have.
The role of rental dwelling insurance
Your first level of protection as a landlord is through your rental dwelling insurance policy (also called a landlord’s policy). Note that a rental dwelling insurance policy is a different from the homeowner’s policy that you have on your primary residence. A homeowners policy insures not just your house, but also your furniture, clothing, etc. The rental dwelling insurance policy only covers the actual structure but provides higher liability insurance.
Section II, part L of a rental dwelling insurance policy lists your business liability coverage. Most people have $100k/$200k or $300k/$600k. The first number is the amount of liability protection per incident and the second number is the maximum annual aggregate coverage. Coverage of $100k/$200k means $100k of coverage for each occurrence of an incident that results in liability, with total annual coverage of up to $200k. It’s not hard to imagine that an incident could result in well over $100k in liability. You will be responsible for any losses beyond your liability coverage.
Insurance and legal fees
It’s important to note that your insurance company provides legal representation in ADDITION to the stated coverage. If you are hit with a lawsuit you call your insurance company and their army of lawyers will take the case from there. They will either fight the lawsuit, or, more likely, settle with the plaintiff. If you have $100k of coverage and your insurance company spends $50k in legal fees fighting a lawsuit, you still have $100k in liability coverage if you lose the case.
Unfortunately, this results in a strange incentive for your insurance company. Let’s say you own a rental property with $100k/$200k coverage. Due to improper maintenance and negligence on your part the house collapses and the tenant is killed. The tenant’s family is understandably outraged and sues you for $1M. Your insurance company realizes that they are almost certainly going lose the case so they decide to settle. They have NO incentive for them to negotiate at any amount over $100k. It doesn’t matter to them if the judgment is for $1M or $100,0001, as the insurance company is only liable for the $100k. You will need to hire your own lawyer to protect yourself from any lawsuit above your policy limits to ensure that your interests are properly protected. In essence, this means that you’ll still need to hire a lawyer if you’re sued for an amount greater than the coverage of your insurance.
Require renter’s insurance
Another way you can help protect yourself is to make it a requirement that your tenants carry renter’s insurance. A renter’s insurance policy will cover their possessions as well as provide some liability insurance for incidents that happen on the property that they are responsible for.
Here’s the reality of lawsuits – virtually all personal injury lawsuits are taken on a contingency basis by personal injury attorneys. The attorneys only get paid if they win AND they can collect from the defendant. They won’t take a case against somebody who is broke, no matter how high the likelihood of winning the case.
Let’s say your renter has a friend visiting them. The friend goes to get a beer from the fridge and slips on some water on the ground. If the friend decides to sue somebody to recover medical costs they will first look to sue the renter. However, if the renter has no money (and no insurance) then there’s no reason to sue them. The renter’s attorney will then look to see if there’s a reason they can sue the rich guy (you). Perhaps they’ll claim the floor was unnecessarily slippery. Perhaps they’ll claim there was a leak in the sink and that’s why the floor was wet. Whether or not there is merit to the claim you’ll still need to deal with them.
However, if the renter had insurance then there’d be no reason to go after you. A lawsuit against the renter has a higher chance of prevailing (they are clearly more likely to be culpable than you are) AND the renter has insurance to pay the claim. Their insurance means you’re less likely to be sued.
The easiest way to prevent lawsuits
A study was done a number of years ago about why doctors get sued for medical malpractice. The finding? Doctors who were seen as rude, in a rush, or uncommunicative were more likely to get sued than doctors who were seen as compassionate and accessible. The rate of malpractice lawsuits had nothing to do with the doctor’s medical knowledge or abilities.
What can we, as landlords, learn from this? Well, if you don’t want to get sued then don’t be a jerk. This won’t prevent all lawsuits, but it will cut down on a lot of them.
This article is about protecting yourself against unpredictable or unknowable liabilities. This is not intended as advice on how to be a slumlord. If you willfully neglect maintenance or ignore problem reports from your tenants then you deserve to get sued (and lose). Keep your properties well maintained, respond promptly to tenant reported issues, and maintain good relationships with your tenants and you’re much less likely to ever face a lawsuit.
So here’s the big question – how can you protect yourself against lawsuits beyond the limits of your rental dwelling insurance?
There are 2 common ways for an individual investor to get additional protection when holding real estate investments – forming a LLC or getting an umbrella policy. Below is an analysis of both, plus some potential scenarios and my recommendation.
LLC – Limited Liability Company
For new investors forming a LLC seems like a magic solution. A lawyer drafts some paperwork, you get to pick a cool sounding name, and suddenly you own a LLC. It sounds so…official! You’re not just a businessperson – you’re officially a business OWNER! Time to get business cards and find a way to mention your LLC into every conversation – you’re big time now!
Advantages of a LLC
Limited liability – This is the reason most real estate investors want a LLC. Limited liability means that owners of a LLC can not be held liable for acts or debts of the LLC. If the LLC is sued, the plaintiff could potentially win a judgement for the value of everything owned by the LLC, but the plaintiff can’t go after the financial assets of the owners of the LLC.
Here’s an example. Let’s say I own the following 2 rental properties:
- 123 Main Street. This property is valued at $300k ($75k of equity) and rents for $2,000/month.
- 456 1st Street. This property is valued at $200k ($60k of equity) and rents for $1,500/month.
To protect myself against liability I decide to create a LLC to hold these properties. We’ll call this The Money Commando LLC (TMC LLC). We then move both properties into TMC LLC (see below for more information about moving a property into a LLC).
Now let’s say that the tenants of 123 Main Street are sitting on the porch when it suddenly collapses. They are injured and, sensing the opportunity to make some easy money, they decide to sue the “rich landlord” who owns the property.
Here’s where the limited liability comes in – the tenants can sue TMC LLC but they can’t sue me (the owner of TMC LLC) directly. The most that would be at risk in a lawsuit would be the assets of TMC LLC – the equity in both properties ($135k total) plus any other assets owned by the LLC (probably limited to whatever cash is in the bank accounts).
Pass-through taxation – a LLC does not pay any taxes directly. Rather, all income, expenses, and deductions flow down to the owners directly. If you have 1 property and it generates $1,000/month in profits, those profits “pass through” the LLC directly to the owner and appear as standard income on the owner’s income tax statement. Individual income is taxed at rates from 0% to 42.9%.
This is in contrast to a C Corporation, where the corporation itself pays taxes (anywhere from 15% – 39% for Federal taxes), then any remaining profit that is distributed to owners as dividends. The owners then pay Federal taxes of 0%-20%, depending on the owner’s income tax bracket. At the highest rate, a shareholder in a C corporation could have a Federal marginal tax rate of 59% (39% corporate tax + 20% dividend tax) on corporate profits. At the lowest rate the money would be taxed at 15% (15% corporate + 0% dividend tax).
The pass-through taxes result in both lower minimum taxes (0% vs 15%) and lower maximum taxes (42.9% vs 59%). If the LLC is owned by a single entity (either a single person or a married couple), then the LLC doesn’t need to file its own tax return. The profits/losses will appear on the individual’s 1040 Schedule C.
Some landlords don’t like the idea of tenants knowing who they are or where they live. If this is a concern a LLC can be used to hide the ownership of a property.
Real estate ownership is public record so it’s usually pretty simple to find out who owns a given parcel. You can either go down to the county recorder’s office and check the ownership records directly or pay about $25 to use third-party online search service. You just type in an address and the owner’s name and address pops up. If ownership of the property has been transferred to the LLC then a property search will reveal the LLC as the owner.
Of course, if you’re the registered agent and/or the LLC address is your home address then simply having a property owned by a LLC doesn’t provide any anonymity. You’d need to set up a 3rd party to be the registered agent and rent a PO box to use as the mailing address for your LLC. With enough digging it will still be possible to find out that you’re the owner of the property, but at least this will provide a first level of protection.
Why go through this much hassle? Well, in theory being anonymous provides you some advantages and protections:
- In the course of owning and managing rental property you’ll need to do things like raise the rent or evict people for non-payment of rent. People tend to get emotional about their living situation. If they don’t know who you are or where you live they can’t terrorize you at home.
- You can act separately as both the property manager and the anonymous owner. If you decide to raise the rent you can tell your tenants something like, “look, the owner decided to raise the rent. He wanted to raise it $100, but I convinced him to just increase it by $50.” In theory this deflects any anger towards the LLC and allows you to maintain a good relationship with the tenants in your role as property manager.
- If nobody knows that you have money then, in theory, you’re less likely to be sued. Personal injury lawyers won’t take a case if the person to be sued doesn’t have enough money to make it worth their while.
Unfortunately, most of these advantages don’t really apply in the real world (see the “Trying to remain anonymous probably won’t work or help” section below for more information). Owning property through a LLC will provide a basic level of anonymity, but it will not provide protection against a determined plaintiff.
Drawbacks of an LLC
Unfortunately, there are more drawbacks to an LLC for individual investors than benefits.
Moving property into a LLC is sometimes impossible and always painful
As mentioned previously, before the LLC will offer you any protection, you first have to move your properties into an LLC. This can be done either through a warranty deed or a quitclaim deed. A quitclaim deed is the simpler of the two – it just says that you relinquish all ownership rights to the LLC. However, a quitclaim deed does not guarantee that the transfer is effective. If there is a problem with the quitclaim deed you won’t find out until it’s challenged in court by a plaintiff’s attorney in a potential lawsuit. So, it’s possible that you would have gone through all the time and cost of filing a quitclaim deed and, in a lawsuit, the transfer will have been found to be invalid and you’ll have no protection.
The other problem with this transfer is that your lender may not agree to the transfer of the property to the LLC. Lenders want the owner of the property to be the person responsible for the mortgage. If you transfer ownership without your lender’s permission they might trigger the due-on-sale clause in your mortgage, which means the entire balance of your loan will be due. There are many investors who have quitclaimed many properties into LLCs and never had a problem. The usual response is that as long as the mortgage is paid every month the mortgage company won’t find out and won’t care. It’s true that it’s unlikely that your mortgage company will find out about the quitclaim deed, but the reality is that if something happens (a lawsuit, an issue with payment, etc.) they will find out and use it against you.
Also note that it’s no easier to buy a property through the LLC directly. The secondary market guidelines for conforming loans state that only human beings can qualify for a 30-year loan. This means your LLC would only be able qualify for a commercial loan. Then, your LLC would need to show it could handle the loan – that is, the LLC would need to be able to show sufficient profits for 3+ years, the ability to pay back the mortgage, a positive credit history, etc. Given that profits are usually pretty modest in the first few years of owning a rental property, this is an unlikely scenario.
The only easy way to put a property directly into an LLC is to buy a property with cash.
You’ll need more than one LLC
In the example above, we created one LLC (The Money Commando LLC) to hold both properties. Of course, the major disadvantage is that all the properties in an LLC are at risk if there’s a lawsuit involving any one property. As a result, the typical advice is to create an LLC for EACH property you own. Using the above example, if I own 123 Main Street and 456 1st Street, I’d need to create 2 LLCs. These are typically named something creative like “The Money Commando 123 Main St LLC” and “The Money Commando 456 1st St LLC”. You now have to go through the creation and filing process for 2 LLCs. I currently have 8 rental properties – you can imagine what a hassle it would be to keep up with the yearly paperwork on 8 LLCs.
You might still need a lawyer
As I mentioned above in the section about homeowner’s insurance, if you are sued for an amount above the coverage limits for your policy, you’ll still need to hire a lawyer to protect yourself. Although an LLC caps the amount you can lose in a lawsuit (the most you can lose is the value of the assets in the LLC), it does nothing to protect you against the likely scenario, which is a lawsuit that is above your homeowner’s policy limit but below the value of the LLC’s assets. You will need to pay legal fees to defend yourself and, if you lose, you’ll still be liable for losses.
An LLC is expensive
There is an initial filing fee to set up the LLC and a licensing fee for each year the LLC is active. The fees vary from state to state, but here are some sample fees:
- Arizona – $50 filing fee, $100 every other year (equivalent to $50/year)
- Delaware – $90 filing fee, $250/year
- California – $70 filing fee, $800/year fee for LLCs with gross revenue (not profits) of <$250,000
- Texas – $300 filing fee, $0 ongoing costs for LLCs with gross revenue of <$300,000
As you can see, the costs are reasonably high for each LLC, and if you hold multiple LLCs the costs can get ridiculous. If I were to create 8 LLCs the cost would be:
AZ (least expensive initial)
- Initial cost = 8 properties * $50 = $400 initial fee
- Yearly cost = 8 properties * $50 = $400/year
TX (most expensive up front, no yearly cost)
- Initial cost = 8 properties * $300 = $2,400 initial fee
- Yearly cost = $0 (assuming revenue <$300,000)
CA (most expensive yearly)
- Initial cost = 8 properties * $70 = $560 initial cost
- Yearly cost = 8 properties * $800/year = $6,400/year
As you can see, different costs for different states, and some are more expensive up front, some are more expensive each year, etc.
But that’s not all. These costs assume you handle all the paperwork yourself. You can assume an additional $100 or so for a very low cost LLC filing service up to $1,000 or more for an actual attorney to handle the LLC formation on your behalf.
Your LLC will either need to be created in the state where it holds property or it will need to be registered in that state. There’s not a lot of value in creating an LLC in another state and registering it somewhere else, as you’ll end up paying 2 sets of fees instead of one. The only time that would conceivably make sense would be if you really, really only want to have 1 LLC to hold properties in multiple states and are willing to pay extra for this “convenience”.
If you’re registered out of state you’ll need a local “agent”. Various legal services will act as your agent for an additional $50-$100/year.
An LLC might not protect you anyway
An LLC will protect your personal assets from a lawsuit against your LLC, but it will not protect you if you get sued personally. Consider this situation – a tenant calls you because one of the boards on the stairs is loose. You nail the board back into place. The next week the board comes loose and causes one of the tenant’s kids to fall down the stair, breaking his back and becoming paralyzed. The tenant sues you for $2M for pain & suffering, medical bills, and future lost wages. This will wipe out the assets in your LLC, but you believe your personal assets (house, car, investments, etc.) are protected, right?
Because you did the work on nailing the board back in, you (not the LLC) were the workman. So unless you also have an LLC or corporation for a construction/handyman/contractor business, AND your contractor LLC billed your rental LLC for the repair (proving that this was a business transaction), you will be personally liable for the work you did. Your LLC will be sued as the owner of the property and you will be sued as the negligent workman for the property.
If you act as the property manager there’s liability from that as well. Maybe you didn’t warn the new tenants about an issue with the property when they moved in – you’ll be sued as the property manager AND your LLC will be sued as the owner.
And if the LLC is sued one of the first things the plaintiff’s attorney will do is to try to “pierce the corporate veil”. This means they will attempt to show that the LLC was your alter ego rather than a true separate entity. If you’ve paid a personal bill from your LLC bank account or haven’t followed other formalities (holding yearly meetings, documenting them with contemporaneous meeting notes, formally passing new bylaws by shareholder vote, etc.) your LLC will offer no protection of any kind. Any lawsuit against the LLC will flow straight to you and you’ll be personally liable for any resulting judgement.
Trying to remain anonymous probably won’t work or help
Trying to remain anonymous only works if you’re not also operating as the property manager or otherwise involved in the property. If you’ve financed the property there will be a mortgage lien in your name on the property. Identifying the owner of the property would be trivial in any of these cases.
As to actively deceiving your tenants about being the manager but not the owner – I don’t think it’s smart to be dishonest to your tenants. As mentioned in the study about medical malpractice, being dishonest is more likely to lead to a lawsuit. This doesn’t mean you need to proactively tell every tenant that you own the property, but the scenario above (where you tell the tenets you talked to the owner about a rent increase) is deceitful at best.
Second, you look awfully suspicious when you go through great lengths to hide the fact that you’re the owner. Once your identity is revealed (and it will be) the judge and jury are going to wonder why you felt the need to hide who you are. You haven’t done anything wrong, but it sure doesn’t look right.
Finally, the stealth wealth argument doesn’t really hold water. If somebody is injured on a property they will sue the owner of the property. They aren’t suing the owner because he’s some random guy that they heard has money. The tenants are suing the owner because he owns the property. And if the tenant initiates a lawsuit then your LLC will be subpoenaed and you will be identified, regardless of how many LLCs and trusts you try to hide behind.
Coming in part 2
In part 2 we’ll look at the advantages and disadvantages of umbrella policies and analyze when it make sense to use an umbrella policy and when an LLC makes more sense.
Related: Part 2