In this post, I’ll share my strategy on how to protect a real estate investment property. Ever since I started investing in real estate, more specifically residential rental properties, I was looking for ways to reduce risk and to protect myself for when something goes wrong.
In the US, anyone can sue anyone for any reason, and while a lawsuit doesn’t necessarily lead to your ruin, it’s good practice to understand the risk factors and to lower risk where possible. The strategies outlined below are what I use for my rental properties in the State of Georgia, but most of it probably applies to other states as well. Before pursuing any of the strategies outlined below, I’d highly recommend consulting with an attorney who specializes in real estate law. That’s what I did.
Common Risk Factors
Negligence is arguably your worst enemy, and no strategy may be able to fully protect you against financial loss if you’re acting in a negligent manner. For example, if you have known (and if there is proof) that the deck overlooking your property’s backyard has been rotten for years and you failed to repair it, you could be found guilty if a tenant gets hurt as a result.
On the other hand, if you could not have known that there was a problem with the deck, maybe caused by a recent thunderstorm, you can still be sued, but the charges are not likely to stick. So-called “Acts of God” generally pose little risk to you.
If you have financed your rental property through a loan or mortgage, the chances are that you have a so-called landlord insurance. That’s pretty much the same as a homeowners insurance, but it’s specifically meant for investment properties. If that’s the case, then one of the things you need to make sure is, that your property is not underinsured. So in other words, the amount your property is insured for matches the real market value and the amount it takes to rebuild the house in the event it gets destroyed.
Additionally, it’s important to make sure your tenants have a so-called renters insurance, which protects their personal belongings, such as furniture. That’s important because, in case of a fire, they can file a claim with their insurance company and not sue you for the loss of their personal property.
How to protect investment property
When I started investing in real estate, I owned all my investment properties:
- Each property’s warranty deed (or title) was made out in my name
- The mortgages were in my name
- I was the landlord on each lease
That kept things certainly simple, also from a tax perspective. The disadvantage of this approach was that an issue with one of the properties (caused by negligence or otherwise) could potentially lead to loss of everything else I owned. So hypothetically, if a tenant gets hurt in one of my rental properties, sues me for 5 million dollars and gets the right, I could risk losing all the other properties, including my primary residence.
The Limited Liability Company
One of the more common recommendations on how to protect an investment property is to put it into a Limited Liability Company (LLC) or a similar legal framework. As the name implies an LLC limits liability of its members. What that exactly means may vary from state to state, especially as it related to real estate. For the State of Georgia, it’s considered best practice to transfer ownership of an investment property to an LLC.
It may be overkill, but my recommendation is to create a separate LLC for each rental property you own. That way an issue with one property doesn’t negatively affect another since they are owned by different legal entities.
A word of caution: Transferring the title of a property you took out a mortgage for to someone else (a natural person or a legal entity) constitutes a sale in many states. Technically that allows the the company servicing your loan or mortgage to ask for immediate and full repayment of the outstanding loan. Neither my real estate attorney nor my mortgage broker have ever heard of that right being executed but it’s a risk you need to consider.
When signing a lease with tenants, make sure that not you but the LLC is the landlord since there is risk involved with both the owner of the property as well as the landlord.
I highly recommend you talk to a tax professional who understands your particular tax situation before making decisions that could negatively impact you. In my case, I found it to be most beneficial to operate so-called single member LLC’s – also called disregarded entities, from a tax perspective. That means each LLC only has a single member (owner), rather than multiple (i.e., You and your wife). That way, all earnings are reported on the member’s tax return. That keeps things simple since you don’t have to file multiple returns.
How to Handle Multiple LLCs
To reduce risk and liability to a minimum, I founded a dedicated LLC for each rental property. So after closing on a property, I had the title transferred to the newly created LLC. Additionally, I founded an LLC that would own all the others. So the final framework looked something like this:
- ABC Investment, LLC
- Property A, LLC
- Property B, LLC
I am the owner of ABC Investment, LLC, which owns Property A, LLC and Property. The disadvantage of this approach is that you have to pay annual registration fees to the state and city each year. But that’s a price I was willing to pay for getting most protection, even if it may seem overkill.
Each Property LLC is not only the owner of the property but also acts as the landlord. To consolidate financials, however, rent is paid to ABC Investment, LLC. I chose this route because I wanted to start “building credit” for an LLC so that I could, one day, take our loans in its name.
To build credit you have to create debt, and since nobody is going to give your brand-new LLC a mortgage, you have to start with a bank account and credit card. To get either one, you need a so-called Federal Employer Identification Number (FEIN), also known as a tax ID. Registering one is free and easy via IRS.gov. Once you have your FEIN, you can apply for a bank account and credit card.
Other tips to protect real estate
In addition to all the above, I also signed up for a so-called Personal Umbrella Insurance, which covers losses not covered by your regular auto or homeowners policies.
My Strategy Summarized
In summary, below are the steps I took to cut risk and liability of owning an investment property and operating a property investment company:
- Avoid negligence
- Each property is owned by a separate LLC (Property LLC)
- Each Property LLC acts as landlord
- Investment LLC owns all Property LLC’s
- All financial matters are handled through Investment LLC
- Investment LLC builds credit
- Personal Umbrella Insurance covers potential excess losses
If you have a different strategy on how to protect real estate investment property, please let me know by leaving a comment!
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