What are the risks involved in owning rental real estate? The law treats the property owner as the guarantor of the safety of his tenants and their guests. If anyone is injured on a property, the owner will generally be held responsible. If someone slips and falls on your rental property and sues you, what can happen? If you own the property as an individual all your assets would be at risk, including your home, your investments and your savings. It is possible to insure against risks, but the insurance might be more expensive than other options, and could be cancelled if there are claims.
The threat of a lawsuit from a tenant, visitor, buyer, seller or lender, can usually be contained by using the correct legal structure to hold the property. Almost always, this is accomplished with a business entity known as a Limited Liability Company (LLC). The LLC was developed as an alternative to traditional corporations and partnerships. Typically, corporations protect the owners against personal liability for business activities but involve relatively complicated tax and record keeping requirements. Partnerships generally minimize the tax and record keeping, but they offer no liability protection. All 50 states have laws allowing LLCs.
The highlights of an LLC:
- Owners are called members. The law specifically states that no member is personally liable for the obligations of the LLC. That means that a member cannot be sued in connection with any matter concerning the LLC, unless there is personal negligence involved.
- An LLC with more than one Member can elect to be taxed as a partnership, and files a partnership tax return. There is no separate tax at the LLC level such as there can be with a corporation, and all items of income or loss pass through to the Members’ personal tax returns. If it is an LLC with a single Member, the LLC can be disregarded completely for tax purposes, and all income and loss are reported directly on the personal tax return using a Schedule C.
- An LLC has a much less formal structure for maintaining records and is not required to conduct annual meetings, issue shares or prepare annual minutes. There may be good governance reasons for doing so, but LLC laws do not make that a requirement. This is a significant advantage over the corporate form of doing business since many corporations become worthless in the absence of adequate record keeping.
- The steps that are required to create and use an LLC are spelled out in each state’s legislation. In Virginia, Articles of Organization are filed with the State Corporation Commission. This document specifies the name of the LLC, the name(s) and address(es) of the member(s) or the manager, as well as the registered agent. The filing can be done by mail or online. If filing online, the fee can be paid by credit card with a nominal convenience charge, and the Certificate of Organization is granted immediately. It’s possible to set up an LLC on your own, but it is usually a good idea to consult with an attorney to make sure you’re getting all the asset protection and tax advantages that are available to you.
- If there is more than one member in the LLC, it is adviseable to prepare an Operating Agreement to specify how the LLC will be governed, and who has what responsibilities.
- The property must be transferred into the LLC with a deed.
Because the laws governing LLCs specifically state that no member can be named in a lawsuit against the LLC, it achieves the necessary protection from a tenant lawsuit. However, it is worth noting that if an owner of rental real estate is sued based on activities unrelated to the rental property, such as medical or legal malpractice or an auto accident, a membership interest in an LLC is similar to any other types of asset. If there is a judgment against you, the creditor may be permitted to either foreclose on your membership interest or he can ask the court for a “charging order” which allows him to collect your share of any distributions from the LLC. Either remedy can cause you to lose a valuable property interest, so additional planning to complete your asset protection should be considered. There are many different strategies available for protecting these LLC interests.
What if you have more than one rental property? The question is whether each property should have its own LLC or whether they should be grouped together. Ideally each property should be owned by its own LLC. The purpose is to isolate each property from the liability of the other. Consider the example of several properties in the same LLC, where the tenants in one property are injured. The injured tenants, as plaintiffs in a law suit, sue the LLC, which exposes the equity in all of the properties, not just the one in which the injury happened. If each property was in its own LLC, the risk of loss would only be to the property at which the injury occurred, jeopardizing only the investment in that property.
Once the LLC is formed, it is necessary to deed the property to the LLC, or you will still be liable as the record owner of the property. You should consult your insurance company to advise that the LLC now owns the property. Most insurance companies will add the LLC as an associated party without any change in premiums. You may also want to investigate an umbrella liability policy to increase the amount of coverage on the rental property.
Estate Planning Aspects:
An additional benefit of transferring rental real estate to an LLC is that you can move assets out of your estate by making gifts, thus reducing estate taxes. If you form an LLC and give your children a certain ownership interest in it each year, you gradually transfer ownership of the rental property while moving the assets out of your estate. You can create voting interests and non-voting interests, so that you retain the right to dictate what happens. LLCs are a good way to set up the ownership of a family vacation home, so that everyone’s rights and responsibilities are specified in the Operating Agreement. Currently every one can give anyone a gift of $14,000 per year without triggering the need to file a gift tax return, and the gifts are not taxable to the recipient. The lifetime gift tax exemption is currently more than $5 million.
