Holding commercial or residential real estate property includes assumed risk that must be managed effectively. Landlords can be subjected to many forms of litigation, ranging from personal injury to environmental contamination. Not to mention the inherent financial risk that comes with any form of investment (financial risk exposure typically remains the same with the exception of “non-recourse” loans). As a result, I recommend that every real estate investor sets up a separate business entity to hold their property portfolio. The entity best suited for real estate is an LLC, as corporations will be subjected to double taxation.
Why Choose an LLC?
An LLC will provide landlords personal liability protection for business debts and claims. This means that if a business cannot pay a creditor – such as a supplier or bank – the creditor can’t go after an LLC member’s house, car or other personal assets (this will be different for different states. Idaho residents have approximately 100k in protection on their personal residence, everything after that can be exposed. This has nothing to do with the LLC though. The purpose of the LLC is to isolate the risk. As I mentioned before, investors usually have to assume personal risk in order to borrow money. There are always exceptions to this rule as is the case with a “nonrecourse” loan). Therefore, LLC members only stand to lose the money they have invested in the separate LLC business entity.
There are some landlords out there that may be considering setting up a separate S or C corporation for their real estate portfolio. I would not recommend this. One of the main reasons real estate investors should avoid S and C corporations is double taxation.
Double Taxation: Corporations receive double taxation on dividends. The corporation pays corporate tax and the individual share-holders will pay taxes on the dividends. On the other hand, an LLC is a ‘pass-through’ taxation entity – the profits and losses pass through to the owners, who then record them on their personal tax statements. Each LLC member must make quarterly estimated tax payments to the IRS.
Limited Liability Exceptions
As with corporations and other business entities, LLC members are not given absolute protection. Members will not be protected under the following circumstances:
– Personally injures someone
– Personally guarantees a loan for a business in which the LLC defaults
– Fails to deposit employee taxes
– Reckless actions on behalf of the business
– Treats LLC as an extension of personal affairs. This is a big one as a court will likely conclude that the LLC doesn’t really exist and that members are conducting business as individuals and will be held personally liable for their actions.
Additionally, members can operate their business in a way that causes a “piercing of the corporate veil”. This means that members of the LLC are not performing the expected actions of an LLC – such as regular member meetings, creating a formal operating agreement, opening a separate business checking account, registering the LLC properly with the state, or obtaining a federal employer ID number. Piercing the corporate veil will bring personal liability risk. Make sure all official LLC registration requirements are fulfilled and that your internal operating agreement in no way violates LLC code.
Multiple LLCs for a Property Portfolio?
Many lawyers and accountants recommend that investors set up a separate LLC for each investment property. Multiple entities prevent liability from one property spilling over to another investment property. For example, a tenant sues you for $600,000 for a claim against house A, which is only worth $500,000. If a landlord was holding all of their properties under a single LLC entity then the additional $100,000 liability could be applied against house B, even if house B had nothing to do with the claim.
On the other hand, if the landlord has a separate LLC set up for each of its properties, the creditor could only go after house A. House B would be protected from any external liability (provided the corporate veil had not been pierced). The downside of this is several LLCs means taxes and bookkeeping become increasingly complicated.
Another good way to protect property against liabilities is to have comprehensive insurance coverage. This includes general liability insurance, physical assets, renter’s insurance, umbrella insurance, and even an adequate loss of income clause. Insurance can also protect personal assets in the event that the LLC’s protection is ignored.
All real estate investors should consider setting up a separate LLC business entity in order to protect themselves from personal liability. However, limited liability protection is not absolute. If members act in a way that pierces the corporate veil (as mentioned) then the LLC will dilute their limited liability protection. For those investors with multiple property holdings, it is recommended that they set up a separate LLC entity for each property. This will help prevent liability spilling over from one property to another. Finally, reinforce LLC protections with a comprehensive insurance plan that includes at least general liability, asset protection, and added umbrella insurance. It is highly recommended that you also require renter’s insurance for tenants as well as a loss of income clause that will keep you afloat in the event of unforeseen property damage.
Is there anything you’d like to add? Let us know.
By Robbie Richards.