One significant disadvantage of holding properties in an LLC is that you may not find a lender willing to finance the properties while the ownership is in an LLC. You may also not be able to secure the lowest interest rates with the lower fees.
I own two residential rental properties, and the first piece of advice I received years ago from both my accountant and my lawyer was to create a limited liability company (LLC) for each building. Their advice was excellent and applies today, and the foreseeable future as well.
An LLC protects the owners from forfeiting any personal wealth in the circumstance that they are sued by tenants for any situation for which the owners may be at fault. The LLC caps the amount for which an owner may be held liable to the market value of the property itself and nothing beyond that. It is legal protection.
If I decide to personally rewire the circuit box of one building and not engage an electrician, and a tenant suffers injury from that action, the tenant will be financially compensated from either the building insurance policies or lawsuits against the LLC or both. But not from me, personally. The personal property and/or personal wealth of the owners is off limits legally.
With that being said, your advice results in both the owner, and by extension his offspring, being exposed to a potential loss of personal wealth, as their personal wealth is not protected from lawsuits being brought by tenants.
In addition, each of my properties is held in trust for my survivors. The LLCs are the official owners of the properties. The trusts guarantee ownership of these buildings is passed on according to instructions coming into play upon our passing. A relative is both trustee (trustee’s deed) and registered agent (LLC).
I don’t disagree that the advice I was given is sound and that most real estate investors follow the advice that your accountant and lawyer provided. In fact, most larger real estate investor clients also handle their holdings this way.
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However, I will stand by advice that it isn’t necessary for all small real estate investors to use LLCs to hold and own their properties because they may not have the means to overcome some of the disadvantages of using LLCs, which are more easily overcome by those who own larger portfolios.
One significant disadvantage of holding properties in LLCs is that you may not find a lender willing to finance the properties while ownership is in LLCs. You may also not be able to secure the lowest interest rates with the lower fees. Some of these loan programs will carry interest rates that are quite a bit lower than those available to real estate investors who hold properties in LLCs.
The second disadvantage is that some small real estate investors will believe that the legal protections they have under the LLC are sufficient and they may not carry enough insurance coverage for different types of insurable events.
Let’s say, you do have someone injured at an investment property and you have only $500,000 of liability insurance. If you are sued and lose, you can lose your building. Given a choice between spending money on the costs of an LLC and other annual costs relating to owning and accounting for an LLC, a small investor who has just one or two properties might find it less expensive or onerous to pay for increased insurance coverages, which to them might be worth more than the protection afforded by the LLC.
I don’t disagree that the gold standard of real estate investing may include having good insurance coverages and owning the property in the LLC, but everything costs money, and sometimes people make different choices.
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Lastly, I think you’re mistaken in your assumption that you can make that electrical improvement to the property and not find yourself sued. When you hire an electrician to do the work, they do it poorly and someone is hurt, the electrician and the building owner will both be sued. I suspect the same will occur when you do the electrical work. The injured person will sue you as the person who did the work and will sue the LLC as well. When the dust settles, you might find that both you and the LLC lose, and you may have to pay out.
When small real estate investors are closely involved in the day-to-day operations, repairs, maintenance and management of a rental property, they open themselves up to personal liability for the actions they take in the activities they perform at the property. I doubt that investors would be able to shield themselves from liability due to poor workmanship, poorly shoveled sidewalks and driveways, or from other decisions that the investor might take that might increase their personal liability for their actions.
Don’t get me wrong, LLCs are great. Many real estate investors use LLCs, but they also use management companies and third parties to do things for them. The LLC should shield its owner from personal liability from those ownership activities that relate to the LLC functions of owning real estate from a passive point of view.
I still encourage real estate investors to think about using an LLC. But that advice goes hand in hand with a much longer conversation about the costs of owning and insuring real estate in an LLC, what to do about estate planning, and a discussion about things an investor may do with a property that may lead to personal liability.