When I bought my first house back in 2003, I had plans to live there for a couple of years, fix it up, and then turn it into a rental property. The idea sounded simple enough, but I ran into a lot of headaches along the way.
I knew location was important, but I didn’t know where I should be looking. I also didn’t know how to properly determine cash flow and ROI (return on investment). And I didn’t take into consideration that an older house would likely need more work done to it. To top it all off, I thought I was a better handyman than I actually am! 🙂
I got really lucky though.
It took a lot more time and effort than I anticipated, but eventually things worked out pretty well. I’ve had the same tenants in the house since 2009 and they’ve paid off quite a bit of that mortgage for me. When all is said and done, I don’t really make much, if any, money on it each month. But I also don’t really worry too much about it either since I have a property management company handle everything for me. And it will be paid off in the next six years, so the income will be much better at that time.
Most importantly though, I learned a lot and didn’t make those same mistakes when I bought my next rental property – a duplex that cash flows nicely every month.
But the thing I want to share with you today is something that has the potential to be even more valuable than anything when buying rental property… protecting your assets.
Until recently, I didn’t do enough to protect myself from potential liabilities. If someone slips and falls on the sidewalk of your rental property (or even says they slipped and fell), that becomes a possible lawsuit. There’s an old saying that goes:
“It’s not a matter of if you’ll get sued, it’s a matter of when.”
A big lawsuit against you could cost you not only your rental property, but your own house, your savings, and more. You need to seriously consider this as a warning. The question becomes:
Do you want that lawsuit to be against you or against a company that holds your rental property?
Hopefully, you’re thinking that a company makes the most sense. So how do you go about setting something like this up? Well, you definitely want to talk to an attorney before making any moves, but I’ll tell you what I’ve done for my situation.
Limited Liability Corporation (LLC)
The first thing that I did was to form a Limited Liability Corporation (LLC). An LLC is a business entity that allows for liability protection. The LLC lets you put your business assets (e.g. rental property) in a company which separates it from your other assets. If done correctly and a lawsuit occurred, the person suing can theoretically only go after the company’s assets thus protecting you and your other personal assets.
This is supposed to make it so they can’t go after your personal residence or personal bank accounts or anything else that is not in the name of the LLC.
Pretty big deal, right?
Forming and setting up an LLC
Forming an LLC is actually pretty easy to do but it does vary a little bit from state to state (although you don’t even need to form the LLC in the state you live). In a nutshell though, you are basically telling the state what your company is and does. They charge you a small fee ($125 in my state) and then they issue you some pretty paperwork called the Articles of Organization. That’s about the two cents version from the state side.
The hard part now falls on your shoulders (which really isn’t too bad). The big thing you need to do is to put the property into the name of the LLC. This can be done with a simple quitclaim deed that an attorney or title company can do for you. Of course, there’s a charge for this as well – the cost to file with the state ($65 in my state) and any fees from your attorney or title company.
Now here’s an important note. Unless you own a property free and clear, you probably are under the shackles of a bank. Most banks don’t want “their” property in a name other than yours. In fact, in small print, most of the banks have a due-on-sale clause that you signed off on saying that you can’t put the property under someone else or something else’s name. If that’s the case, they have the power to actually call the entire loan due if they decide to call you out on it.
However, even though that’s technically the case, I haven’t heard of that ever happening. If you’re paying them on time every month, most banks don’t seem to really care, but be aware that that’s out there regardless.
The other thing you should know is that an LLC only isolates off what’s not in it. So if you have multiple properties all under the same LLC, someone suing your company could actually go after all those other properties as well. One way around that is to form multiple LLCs – one for each property. This starts to become a little bit of an annoying administrative headache though. Some states now offer a newer type of incorporation called a Series LLC (SLLC) that can make this a little easier to manage and should provide the same protection.
I personally have decided that I will have a couple of properties in each LLC (at least for the time being). I do give up some of the protection, but I feel it’s a happy medium over the headache of creating a new LLC for each property.
Operating an LLC
Because an LLC is designed to help separate your business assets from your personal assets, you should operate it more like a business as well. Here are a few recommendations:
- Create an operating agreement. This is a document to lay out the “rules” for your LLC. For instance, this might include information on how periodic meetings are going to work and minutes that will be kept. You can easily find some samples to help guide you through by using your friendly-neighborhood Google search.
- Record meeting minutes on a periodic basis. Yes, it might just be you in your LLC, but you still want to document whatever actions that are taking place. Remember, your goal is to make this into a business entity so you need to operate it like one.
- Create a separate business checking account. As an LLC, you are able to freely transfer money between the business account and your personal account, but why not treat it a little more like a business? Have all rent get deposited in the business account and pay your property expenses from that account. Then you can transfer money periodically to your personal account as a salary (if your property is actually cash flowing!).
Are all of these actions required by law? No, but each of them makes it harder for someone suing you to “pierce the corporate veil” and get to your stuff. Run your business like a business and you should come out further ahead if you ever need to spend some time in court.
One of the big concerns that some people have with setting up an LLC is that they are worried that it will either make their yearly taxes harder to do or it will hinder how much they get back.
Here’s the good news, according to my CPA, if you’re worried it will complicate your taxes, it really won’t. LLCs provide for pass-through taxation, which means you can just handle the taxes for your property on your personal return just like you would if you didn’t use an LLC.
The other form of protection that I have in place is an umbrella policy. This is a nice, cheap insurance policy designed to cover liability costs for anything over what your homeowner’s or auto insurance policy limits. It may even cover legal costs in the event you are sued.
The reason it’s so cheap is because it’s not something that’s usually used. Most of the time, your claims are within the realm of your regular insurance limits. However, when that one day passes that causes you to run past your limits on your normal policy, you’ll be glad you have this in place.
The umbrella policy is not something you would buy for each property you own – it’s tied to you (and you would add your LLC as an insured member on it as well). Then it just covers everything.
I recently upped my policy to cover $2,000,000 for each occurrence and I pay $250 a year for it. Obviously, I’m hoping to never use it, but I sleep better at night having it.
So, those are the choices that I’ve opted for with my rental properties, but they are far from the only choices out there. There are S-Corps and C-Corps… and lions and tigers and bears, oh my! Your goal shouldn’t be to copy my plan, but hopefully this gives you some ideas to get the ball rolling on getting some protection in place for yourself.
Are you in the real estate game yet and how do you run things to help in protecting your assets?
As always, remember that I’m not an attorney. You should definitely talk to one before making any moves to determine the best asset protection for your own investments.
Thanks for reading!!