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.
An LLC Won’t Protect the Value of Your Real Estate Property
First, this may seem obvious, but it’s worth mentioning this since a lot of investors get hung up on the idea that an LLC means they’re completely protected. So it’s worth pointing out that if someone has 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 Won’t Do Anything if You are Sued Personally
Sometimes people are confused about what an LLC does. If someone sues you as a person for something you did, they can go after your assets, including LLCs that you own. It doesn’t make any difference if you have assets in an LLC or not if they are suing you personally.
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.
An LLC Also May Not Protect Your Assets From a Liability Lawsuit
An LLC might also not do the one thing investors thought it would do for them — offering protection of their personal assets from lawsuits. People often assume that if their rental property is in an LLC, and something bad happens to someone related to that rental property, they don’t have to worry about someone filing a lawsuit and taking their own personal assets that are outside the LLC. But that may not be the case.
Let’s look at an example of why that is. Although it rarely actually happens, if someone did slip and fall at your rental property, the assumption is that they would have to sue your LLC if the property is held in an LLC. And therefore, at worst they could bankrupt your LLC and take the assets (the properties in it). But what prevents them from just suing you directly? It turns out, maybe not much.
If they can reasonably make a case that you were personally negligent in a way that caused their harm, there’s no reason they can’t sue you directly. All they have to do is be able to have a reasonable claim that you should have repaired that walkway, or you should have made the stairs less slippery, or whatever the specific issue may be. Making that claim is especially easy to do if you’re managing the property yourself. Then it’s clear that you are the person who is ultimately responsible for ensuring safe conditions at the property, so they can just sue you directly. Is this situation, your personal assets may not be protected by the LLC.
But that’s not all. Even if there is no reasonable way for them to claim that you’re personally responsible for their harm, even then the LLC still might not the ironclad wall of protection people believe to be. It may still be possible to “pierce the corporate veil”. 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.
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!).
An LLC May Make Things More Complicated
Even though an LLC doesn’t offer much protection, it may offer some protection in some scenarios. So, does it make sense to just go ahead and put your rental properties in an LLC anyway? Maybe, but keep in mind there are downsides to having real estate in an LLC rather than owning it in your own name.
The biggest complication is when it comes to mortgages. 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.
The reality is 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 if they do, you may find yourself in a bad situation. Moving a property into an LLC will likely 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 or face foreclosure. 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. But it’s not a situation that you want to end up in. But you may want to seek more advice on the specifics in your state and situation. The specific conditions that will trigger the due on sale clause may vary depending on your mortgage and your state.
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.
