It is common knowledge that it is wise to hold real estate in the name of a business. Why? It shields the owners from personal liability. For example, a judgment creditor would obtain a “charging order” or lien on the sums due to be paid to the judgment debtor and not a transfer of the LLC interest itself.
Additionally, LLCs have become the entity of choice because it avoids the “double taxation” of corporations. [Note: If this is a foreign concept, please see the prior blog posts on LLC basics and formation]
Most real estate investors form an LLC to purchase real estate. However, there are still risks associated with using LLCs to purchase real estate.
RISK NO. 1: IMPROPER FORMATION
In my experience in representing investors, they have a sense of urgency that is unparalleled. When there is a deal cooking, it is “all hands on deck” to “bring it home.” However, this tends to cause investors to sometimes cut corners and ignore the details. One area where this occurs is in the operating agreement.
A few years back, I represented an out-of-town developer who used a form operating agreement to secure a deal in Wisconsin. When the deal fell through and proceeded to litigation, the shoddy operating agreement came back to haunt him in that the court ruled to “pierce the corporate veil” and hold the developer personally liable for the breach of contract. Up until that point, veil piercing was something you only read about in law school. But I saw it with my very eyes. It was an extremely sobering experience and one I would not wish on anyone. The devil is literally in the details.
RISK NO. 2: PIERCING THE CORPORATE VEIL
I have talked about this in other posts. Courts generally loathe disregarding the corporate form. However, there are several factors that may cause the court to hold LLC members personally liable, including but not limited to, not having an operating agreement, commingling personal and business funds, failing to observe corporate formalities. Remember, creating an LLC is like having a child, it should have its own identity and not be treated as an extension of the members. If you keep that in mind, you will be fine.
RISK NO. 3: NOT HAVING THE PROPER INSURANCE
In addition to having the LLC, risk management dictates that you take precautions to guard against foreseeable risks. That is the purpose of insurance, to mitigate the risk of loss. Especially in the case of real estate, where premise liability is a real thing and “mayhem lurks around every corner.”
I have had cases where houses burned down because they were struck by lightning, houses suffered “wind damage” or were located on a flood plain. They do not call it “acts of God” for nothing.
MINIMIZING/ELIMINATING RISKS
Now that I have sufficiently frightened you, let me tell you how to minimize or eliminate these risks.
Separate each real property parcel in a different entity.
There are many ways to structure your real estate business. In commercial real estate, lenders typically want single assets LLCs. The property is big enough and the deal complex enough where they need a separate LLC. The reason being it limits the liability of the borrower and protects the interests of the lender.
This also applies to the residential investor. However, single asset LLCs are a nightmare from a tax and administration standpoint, as the overhead is often cost-prohibitive since the profit margins in the residential space are much slimmer.
A middle of the road approach for the residential investor is to bundle the properties and set a limit per LLC. Perhaps set a limit of two to five residential properties per LLC. A real estate investor friend of mine also stated that you can also set a value limit for each LLC. For example, when the total value of the real estate reaches $500,000, you would create a new LLC. As you can see, there are many ways to manage the costs associated with maintaining your real estate LLC.
Separate the real estate owner from the property management.
If the management company is sued for failing to maintain the property or for some other reason, the owner may escape liability, depending on the claims. And if the property management company is a true third party, there may be insurance protection and other indemnities that will protect the owner of the real estate. However, this presumes that the real estate owner did his due diligence and hired a reputable property manager.
LLC operating agreement contains an owner indemnification provision.
Again, I cannot stress the importance of a quality operating agreement. Most operating agreements have a provision where the LLC is required to indemnify the members if they are sued personally. This means that if someone tries to sue the members for the actions of the LLC, barring crime or fraud, the LLC is obligated to take up the cause.
Have your own insurance; become an additional insured.
At the bare minimum, the LLC should have a general liability policy. Speak to an insurance professional about other coverages that may be appropriate based on your business and situation. Also, have any tenants and/or property managers add you as an additional insured on their policies, where appropriate.
And please, I implore you, read your insurance policies and make sure you understand the contents. The law presumes that an insured has read and understands the terms of the insurance policy. If you do not, please speak to your agent, an attorney, or another knowledgeable party. In all honesty, it is good practice to revisit your insurance situation at least annually and see if there are additional coverages you need.
Observe LLC formalities and proper formation
I know I sound like a broken record, but make sure you have an EIN and an operating agreement. And make sure the operating agreement accurately reflects your business reality. You never know when it may come back to haunt you.
CONCLUSION
The LLC is still the preferred entity of choice for real estate investors. However, it does not mean that there are still not risks. Hopefully, this and the other articles in this series will go a long way in assisting you to structure your real estate business properly. And if you have any questions or concerns, please contact us for a consultation.