Big rewards can be reaped by owning investment properties, but so too can big risks. One common threat real estate investors wish to avoid is personal liability for judgments resulting from a lawsuit. Even the most conscientious owner may one day find him or herself embroiled in a costly legal battle. While it is impossible to prevent lawsuits from being filed—from slip and fall claims to dog bites, environmental contamination claims, and many others–it IS possible for investors to mitigate the costs of such perils. Some of the more common methods of limiting such threats are explored in this article.
Never Hold Investment Property in Your Own Name
Smart investors know that owning rental property in their own name is not the wisest choice when the threat of personal liability is involved, as istypicallythe case with investment properties. It is critical to form and maintain a separate entity to hold title to the properties. While there are many options for holding real estate, including corporations, general and limited partnerships, and limited liability companies (“ LLC’s”), LLC’s are often the preferred choice for a variety of reasons.
A general partnership does nothing, by itself, to protect the owners against personal liability. In contrast, limited partnerships do provide such protection, but only to the limited partners. All limited partnerships must have at least one general partner who is exposed to personal liability for partnership obligations. Although the general partner may be an LLC or C Corporation, this is a more costly method for guarding against personal liability than using an LLC or C Corporation to hold the property since multiple entities must be formed and maintained. However, in some instances, such as when annual revenues exceed $250,000.00, a limited partnership may very well be the best option for investors, in order to avoid the annual LLC fee and franchise tax imposed by the state of California.
For individual investors who anticipate annual revenues below this threshold, a limited partnership is not as attractive as an LLC, which protects all its members against personal liability for company obligations, including lawsuits and judgments, and is generally less expensive to set up and maintain than multiple entities or a C Corporation. LLC’s also have the advantage of avoiding the double taxation which comes with owning a C Corporation.
Many small real estate investors also hold real estate in a trust. Although living trusts are very useful for succession planning and may help protect an owner’s privacy, such trusts do not protect the owner from liabilities arising from ownership of the property, which is the focus of this writing. However, setting up a trust in conjunction with an LLC to hold real estate should be considered since it does add value to the owner in most instances.
What if You Own Multiple Rental Properties?
Real estate investors who own more than one rental property often ask our business law attorneys whether they should hold each of their properties in one LLC, or form a new LLC for each property they own. Although each set of circumstances is unique, our lawyers often advise forming an LLC for each property the client owns.
Here’s why: If someone is injured on just one of the properties owned by an LLC and thereafter sues the company, all of the assets held by the LLC are at risk to satisfy any resulting judgment. For example, ifan LLC owns three properties with estimated values of $500,000.00 each, that’s $1.5 million in assets put at risk by a lawsuit arising from any of the properties, making the LLC a more attractive target to litigants and needlessly exposing all three properties to liability in a lawsuit. By contrast, if each property were held by a separate LLC, only the property held by that particular LLC is generally put at risk, assuming there are no grounds for the injured party to argue that the companies were not properly set up and maintained.In the first example, if a litigant were to obtain a judgment against the LLC, they could place a lien against all three properties until the judgment is satisfied. In the latter situation, where each property is held by a separate LLC, only the property owned by that LLC could be encumbered. As is obvious from this example, the benefit of forming separate entities for each property increases as the value of the properties held by the companies grows.
Another advantage of holding multiple properties in separate LLC’s involves a situation where the investor wishes to obtain a loan against one of the properties. Banks and other lenders often find the prospect of lending to an LLC which owns multiple properties less attractive than separately owned properties since their secured interest (the property being borrowed against) has much more exposure to liability than if they were held separately. In such instances, lenders will often seek a secured interest against all of the properties held by the LLC to ensure their interest in being repaid is well protected.
Owning investment property can indeed be very rewarding. However, smart investors know there are perils to consider before deciding on how to hold such property. With some thoughtful preparation and educated decision-making, investors can reap the rewards of their investment efforts while guarding against the risks.
At Gehres Law Library, our business law attorneys generally recommend a three pronged approach to limiting personal liability for activities related to investment properties. This approach includes: a) forming an entity or entities to hold title to the properties as discussed above; b) preparing well-drafted contracts in order to shift the burden of any threats to others where possible; and, c) obtaining sufficient liability insurance.
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Franchise taxes and fees imposed on LLC’s in California (in addition to any income tax withholding): $800 for LLCs with total gross income of less than $250,000; $1,700 for LLCs with total gross income of at least $250,000 but less than $500,000; $3,300 for LLCs with total gross income of at least $500,000 but less than $1,000,000; $6,800 for LLCs with total gross income of at least $1,000,000 but less than $5,000,000; $11,790 for LLCs with total gross income of $5,000,000 or more.
See our article on Piercing the Corporate Veil: Avoiding Personal Liability for Company Debts at https://gehreslaw.com/piercing-corporate-veil-avoiding-personal-liability-company-debts/ for more information on the importance of setting up and maintaining an entity properly in order to avoid personal liability for company debts.