Disclaimer: This is not legal advice. Please seek legal advice for your particular situation
The cliché situation that rental property owners hear about is “what if your tenant slips and falls and they sue you.” Even people who have never been a landlord have often heard of that hypothetical scenario. Just thinking about that situation has probably prevented some people from getting involved in owning rental properties at all.
One possible solution to reduce that risk is to put the rental property in an LLC. But does that really protect you from lawsuits? The answer to that question isn’t entirely straight forward, and there are a lot of other factors to consider before you decide to transfer your property to an LLC.
Why You May Want to Put Your Property in an LLC
The purpose of putting a property in an LLC is to at least potentially protect your personal assets (outside the LLC) if someone sues your LLC because of something related to your rental property.
It’s worth pointing out that an LLC doesn’t protect your rental property in the LLC at all. If someone wins a claim against your LLC, they can take the assets held by the LLC, which means they can take the real estate, which may be of substantial value.
An LLC also doesn’t protect your rental property if someone sues you personally for something you did. If you personally get sued, and they win, they can go after your assets, including LLCs that you own.
What an LLC may do is protect your personal assets that are outside the LLC in the event that someone sues the LLC because of something related to the property that is inside the LLC. And even then, the LLC may not protect your personal assets. It may still be possible for a plaintiff to “pierce the corporate veil” and sidestep the LLC protection and go after your other assets. The factors that will allow a plaintiff to go after your personal assets vary from state to state. But in general, they may be able to do so if they can prove that the LLC is not really a separate entity apart from you as the property owner, and that you should be held personally responsible for their harm.
An LLC Won’t Affect Your Taxes in Any Way
A single-member LLC is always completely disregarded for federal tax purposes. So you won’t pay any more or less federal tax by putting a rental property in an LLC. The tax calculations “pass-through” to your personal taxes, so the resulting tax is the same whether you have an LLC or not. But depending on your state, there may be fees associated with the LLC, which can be substantial in some states (I’m looking at you, California!).
Mortgage Concerns with an LLC
Most mortgages won’t lend money to a property that is held in an LLC. That doesn’t mean you can’t get a mortgage. There are lenders who specialize in these types of mortgages. But you’ll pay a significantly higher rate in most cases.
Instead, what most real estate investors do when they want to put a property in an LLC is they’ll get the mortgage first while the property is still in their own name, and then later move the property into an LLC without informing the mortgage company. It’s true that in most cases, the mortgage company won’t notice that the ownership of the property has changed.
But it’s possible that moving a property into an LLC could trigger the “due on sale clause” of the mortgage, which means if the lender discovers the situation, they may choose to demand that you repay the loan in full immediately. Some lenders may specifically allow owners to put properties into an LLC they own, so this may not be an issue for some lenders.
If you find yourself in that situation, you may be able to remedy it by changing the property back to your own name, or by refinancing with a different lender that allows LLC property ownership. The specific conditions that will trigger the due on sale clause may vary depending on your mortgage and your state, in some cases moving a property into an LLC you fully own isn’t an issue.
Aside from the mortgage, you may also find the property insurance rates are higher for properties that are held in an LLC. You’ll also need to keep the finances for the LLC strictly separate from your personal accounts.
An Alternative (or additional) Way to Get Protection from Lawsuits
Whether or not you use an LLC, there is something else you should do to protect yourself from lawsuits. You should definitely consider getting umbrella insurance. The type of insurance we’re referring to is insurance that protects you above and beyond the insurance that you may already have, such as auto and property insurance. Umbrella insurance is there to protect your assets in the case of a lawsuit. You can get it through your homeowners insurance company, or separately from companies like RLI or Stillwater Insurance.
Umbrella insurance typically offers coverage that starts with amounts in the range of $1 million or $2 million. When choosing your coverage amount, keep in mind that it’s not unreasonable to get more coverage than the value of your assets. The reason is it doesn’t cover your assets up to that amount, instead it covers lawsuit awards up to that amount.
For the best protection, you might choose to have both an LLC and umbrella insurance. The umbrella insurance may protect you if you get sued, and your LLC might still protect your other assets if the umbrella insurance fails to protect you for any reason.
Are there other reasons you might want to choose to use an LLC?
Even if an LLC doesn’t always protect you from personal liability lawsuits, it does offer you certain kinds of protection. Primarily, it may protect your personal assets outside the LLC if there are debts that are only in the name of the LLC, if those debts end up being larger than the value of the property. So if the business operations that you’re conducting within the LLC (such as a property flip) go badly and it ends up bankrupt, your personal assets outside the LLC should be protected.
Some property owners also prefer to put their properties in an LLC just as a way to offer some degree of anonymity. It’s generally possible to find out who is the owner of an LLC, but it’s an extra step that isn’t quite as easy as looking up a property owner of a rental property. That extra degree of anonymity can be important to some real estate owners.
As always, we advise that you seek advice from an actual lawyer. But when you do, it’s worth asking whether an LLC in your state will actually protect your personal assets from the kinds of risks that you’re concerned about.
