Here's an email I recently received from a reader:
My wife and I own 2 rental properties. Both homes were our primary residences before we were married and we have mortgages on both properties. She lived in a one bedroom condo in a popular, very walkable neighborhood and when we married in 2010, she moved in to my home which is a 3BR 2BA home in a first ring suburb. We immediately rented her condo and despite being unable to cash flow the property, it has gone well and we are very likely underwater on this property so I suspect renting it out is far preferable to selling right now. This year, we moved into a new home to raise our family in an outer suburb and we've rented out the previous home. This is cash flow positive by quite a bit and we're doing very well with it so far. When I bought this home 8 years ago, it had always been my intention to rent it when I left though I didn't anticipate living there 8 years.
I viewed our relative risk on the condo as limited. There are immediate neighbors and an association and the type of tenants have been young professionals or graduate students. I view the risk on the home as much greater as my applicants tended to have poor credit and were walking a bit of a tightrope financially. In addition, this is a single family home so they have more privacy if they were into nefarious doings (We did do a relatively thorough background check to avoid such a circumstance).
In the past, I'd looked at forming an LLC to protect my personal assets in the event something went wrong in this process. At the time, we were only renting the condo and the biggest risk I really saw was our inability to cover the mortgage if we had a long vacancy. We never went down that path because the mortgage was in my wife's name and we could come up with no scenario where a bank would let us transfer the debt to an LLC because the only reason we'd want to do that would be risk of default. Furthermore, our assets were somewhat limited so we didn't take the discussion further. Since we now have a second property, greater risk IMHO, and more personal assets, I would like to reconsider this.
I've spoken to a financial advisor and he suggested creating the LLC, leasing our properties to the LLC and then creating all of the leases with our tenants through the LLC so that if we have issues with tenants or face a lawsuit, only the LLC would be at risk.
My question is this: Have any of you done this? Is this reasonable or is there a better way? Does this even alleviate my concerns from a legal standpoint (obviously I'm not avoiding the default risk, but that is far less of a concern these days than when we were first married)? Lastly, would I need to have something drawn up by a lawyer or can I find a lease between myself and the LLC for free on the web?
What's your advice for him?
You would need to have the deeds transferred to the LC; you wouldn't be able to insulate yourself from liability by leasing the property to the LLC and then have the LLC lease it to the tenant if that is what you are proposing. You should definitely us a lawyer.
Posted by: Matt | July 13, 2013 at 08:05 AM
I meant LLC :)
Posted by: Matt | July 13, 2013 at 08:06 AM
Professional legal advice is needed, however I asked a similar question to a mortgage broker I have dealt with. His answer was that the deeds themselves could be transferred to the LLC, however you would have to keep the mortgage in your wife's name. This may or may not trigger a "due on sale" clause in your mortgage in which the bank could call the note, however it is my understanding this is never done if you are current on payments and the move was strictly for liability protection as the bank still holds a lien on the property anyway.
Again, this is not legal advice, and you would no way remove your liability for the mortgage, but it may at least shield your other personal assets not tied to the home or mortgage from claims.
Check out the forums over at biggerpockets.com, as there are a number of threads on this type of transaction. Hope this was some help.
Posted by: JM | July 13, 2013 at 10:15 AM
I think it's best to transfer the deeds to the LLC (which you've said isn't easy...), but I'm no lawyer and I wouldn't know for sure. Your tenants will be renting a property from the LLC. They would have every reason to believe that the property is owned by the LLC (somebody might want to go after the "property owner" if something nasty happened). It just seems like the whole operation isn't running like a business -- and that's what you need to get full protection. Instead, there's just a business name on the rental contracts, and using personal assets in a business leaves you vulnerable.
I guess the approach could be better than nothing... If you can't transfer the deeds, maybe it's all you've got, and it could protect you if the legal troubles are just landlord/renter disputes. But I don't know if it'd hold up if something catastrophic happened and somebody really wanted to come after you. Again, only a local lawyer can tell you how it would work out.
Posted by: Pat | July 13, 2013 at 11:10 AM
One thing I didn't mention, is just make sure you have a big liability or umbrella policy ($1 million+). Many people feel this is more than adequate protection for just 1 or 2 properties. That may be the most simple thing to do than get bogged down worrying about LLCs, at least as a short term solution. That kind of coverage is not too expensive, and you should have it even if you do have an LLC.
Posted by: JM | July 13, 2013 at 11:19 AM
Professional legal advice, definitely, especially as the nuances will vary from state to state.
Posted by: Sarah | July 13, 2013 at 12:10 PM
Hmm, looks like my comment was deleted. Too tax technical?
Posted by: Mnlandon | July 14, 2013 at 01:59 PM
I'm guessing too long. Typepad doesn't like long comments - another reason I moved www.wealthlion.com to Wordpress.
Posted by: FMF | July 14, 2013 at 02:39 PM
No worries. I'll sum it up. I used to be a practicing tax CPA. There are tax compliance issues to take into consideration depending on the state you live in. I live in California which charges a franchise fee annually. Even if my LLC is losing money I still owe $800 a year to the state - not to mention some paperwork (read accountant fees). For approx. $200 you can get an umbrella police for an extra 1 to 2 million (See JM's comment which is on the money) which should prove enough for most worst case scenarios. Every state is different though, you might not like the LLC route in your state even if an attorney likes to sell the idea of one.
Posted by: Mnlandon | July 14, 2013 at 03:31 PM
LLCs are over-rated when you are starting out.
Many people have listed some of the problems above.
What they have not listed is that even if you do it all right and you make any minor slip ups on a single member LLC or close family owned LLC the courts can still pierce the corporate veil. Any mixing of any business and personal financing (using any personal credit card, paying any bills with a personal check, etc) will be used to show its not a business separate from you personally. Sometimes just having a single member LLC is enough for the court to decide its no different from you. There are strict rules about what is required for an LLC to run as a business. You need to hold annual meetings, have meeting minutes about the business that is decided at annual meetings. You need an operating statement that defines the way the business intends to operate. There are all mostly just window dressing for any small single owner business. But without them the court can easily claim the LLC is not a true separate LLC entity distinct from you personally.
LLC is the big thing in the last decade or so as they are a relatively new corporate structure with not that much case law behind them but have still become the hot topic way for lawyers to claim you can protect yourself from all liability.
There are starting to be cases where the corporate veil has been pierced. I suspect very few small businesses are doing the LLC in a rock solid way that is certain to hold up in court (beside that fact that nothing is certain to hold up in court).
good liability and umbrella policies worth a few million is not that expensive and is far more reliable than an LLC structure for a small business owner.
Go ahead and get an LLC and do what you can. It's not a bad thing to do. Just don't stop there. The umbrella is your real protection, not the LLC.
Posted by: Apex | July 15, 2013 at 12:08 PM
Guess I am curious - why not sell the condo? For an active owner of a rental why not take the loss on your taxes?
Posted by: Joe | July 15, 2013 at 01:34 PM
Apex - are you saying that your umbrella policy covers liabilities associated with rental properties? For example, your tenant's dog bites the neighbor's kid. Neighbor sues you. Would the umbrella policy cover this type of situation? My understanding is that it would not, but I admit I don't understand what exactly it does and does not cover. Do you have a commercial policy for your rentals in addition to a personal policy?
Posted by: BH | July 15, 2013 at 03:35 PM
BH --
Here's how I understand it:
1. The LLC gives one level of protection. But as Apex mentions, that may not be worth a lot.
2. When you buy insurance to cover the property, there's usually liability insurance as part of that. For my properties it's $1 million per property.
3. Separate from the LLC, I have a personal umbrella insurance policy. So if the LLC and the liability insurance don't cover any problems and someone comes after me personally, the umbrella insurance policy covers my personal assets.
Posted by: FMF | July 15, 2013 at 04:01 PM
So the neighbor's kid needs plastic surgery and hires a lawyer on contingency who is incentivized to go after your deep pockets and sues you for $2m. Your homeowner's policy on the rental is $1m. I don't know that in that scenario your personal umbrella would protect you for the other $1m. Again, I could be wrong and in an abundance of caution I am over-insured on a personal umbrella policy. I wonder what I'm paying for, but the marginal cost of buying more insurance is nominal. I think what you really need is commercial general liability insurance. But again, maybe I'm wrong.
I disagree that LLCs aren't worth a lot of protection. Absolutely one should do annual filings (just use a service for this, like capital corporate servicess), add a second member, be careful with record keeping. Then the judgment is absolutely limited to the value of the property because it is "bankrupt-remote" from all your other assets. I feel strongly that once you have a certain net worth (I'll randomly say $1m), you should start using special purpose entities to hold title to every single rental, regardless of the hassle.
Posted by: BH | July 15, 2013 at 04:24 PM
@BH,
It depends on your personal umbrella. My personal umbrella could extend to a total of 5 properties. I specifically asked about that and had each property specifically identified as an extension for the umbrella. So it absolutely would have been covered by the umbrella.
Once past 5 properties mine would no longer extend, so now I have a personal umbrella and a commercial umbrella and both are relatively cheap.
Using a service to do annual corporate filings, being careful not to mix any finances, and having multiple owners listed in the LLC (when you don't even really want multiple owners) to make it less likely they can pierce the corporate veil is all good, but it's a hassle, it's costly, and I would like to know what percentage of LLC's being used for small time real estate investors do all those things? I would happily bet large sums of money that it is no where near 2 digits (might not even be 1 digit).
To each their own I guess. I sleep a lot better having the umbrella than the LLC.
Posted by: Apex | July 16, 2013 at 11:14 AM
Apex – I see your point – the umbrella sense for a newer investor, such as the poster. I would add that the largest benefit of having multiple LLCs (one per property) is that they are bankruptcy remote, meaning that you can bankrupt out of one LLC without affecting your larger portfolio. If the LLC has a non-recourse mortgage and the market fails, you file BK (happened to a lot of smart people during recession –lost most of their fortunes, but weren’t completely destroyed). If your tenant’s dog bights the neighbors kid and insurance doesn’t cover it all (my experience is that insurance companies are in the business of carving out as much as possible and paying as little as possible), you bankrupt the LLC. This is more important for someone with a high net worth or high income or a spouse with high income (subject to being garnished). Also, LLCs give you privacy. The best practice is to get a Delaware LLC (or some other state with good privacy) because you don’t have to disclose the members in the filings and you can use a company as a stat agent, that way snoopy people (or enterprising lawyers) can’t look up who owns the property (without going to court). The two downsides are: (1) they take effort and (2) in some states, especially CA, LLCs are expensive and there are annual filing requirements. In my state, they’re cheap (like $250) and there are no annual filing requirements, so why not do it? Once you feel you have a lot to lose, best structure in my opinion: Revocable Family Trust is a member of Delaware LLC is member of the state LLC that holds title to the specific asset. Name your entities as additional insured on your umbrella policy.
Posted by: BH | July 16, 2013 at 02:03 PM
@BH,
"best structure in my opinion: Revocable Family Trust is a member of Delaware LLC is member of the state LLC that holds title to the specific asset."
This is a great clarification of the differences of our views. You have an entity inside of an entity wrapped in another entity here. Presumably for each property.
It brought to my mind the quote from Winston Churchill regarding the actions of Russia in WWII which was also paraphrased in the movie JFK - "It is a riddle wrapped in mystery inside an enima."
I am a strong believer in the K.I.S.S. principle, I don't like wrapped enigmas. :)
Posted by: Apex | July 16, 2013 at 03:01 PM
"Enima"?
Do you mean "enema"?
If so, that's strange. If not, that's FUNNY!!!
Posted by: FMF | July 16, 2013 at 03:04 PM
@FMF,
That is funny. It's a typo where I dropped the g on the first reference to the enigma. Yes, an enema would seem strange there. However, after creation of a series of complex nested legal structures, an enema might be appropriate corrective action. :)
Posted by: Apex | July 16, 2013 at 03:14 PM
Apex --
I knew what you meant, but I couldn't resist. ;)
Posted by: FMF | July 16, 2013 at 03:16 PM