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This article is presented by LegalZoom.
A frequently asked question in online real estate investing threads is, “Should I form an LLC for my rental property?”
It may seem like setting up an LLC is one more thing to do on a list that can seem so long to a new investor that it’s overwhelming. There’s insurance to research and sort out; there’s the property management company, the rental payments, the accounting…is setting up an LLC really worth it if you’re investing on a small scale, say, into a single unit, at this point? Isn’t it enough to just purchase good insurance?
As a matter of fact, you really, really should set up an LLC for your rental. New investors often don’t realize that buying rental property in their personal name exposes them to lawsuits, tenant claims, and debt collection. An LLC separates personal and business assets, creating a liability firewall.
Let’s consider all the implications in a bit more detail.
What a Lawsuit Could Mean If the Property Is in Your Name
From a legal perspective, becoming a real estate investor is a higher risk, for the simple reason that you will be dealing with a lot of people and situations that can lead to a lawsuit. The most obvious risk comes from tenants, who could sue you for anything from slipping and falling on an icy driveway (which is your responsibility to maintain) to mold in the bathroom.
But risks don’t stop with the tenants. The neighbors could sue you for accidental damage to their property (say, a fence) during repair or renovation work on your property. They might even sue you if a new fence (or tree) accidentally crosses the property boundary onto theirs.
A lawsuit, if it does happen, is always a headache, but if the rental property is in your own name and not under an LLC, you could be looking at a true nightmare.
The biggest risk of not forming an LLC for your rental investment is exposing your personal assets to claims. If you personally are being sued, you could lose your personal savings and even your own home. Depending on the size of your personal assets, your landlord liability insurance policy may not cover all of it.
Even more unpleasantly, if you happen to go through a divorce, if your real estate property is in your own personal name, it’s considered your personal property and can become part of the divorce settlement, just like the house you share with a spouse.
How LLCs Isolate Rental Risk
These are just some of the potential scenarios in which an investor can suffer because of their failure to separate their business and personal assets. Setting up an LLC does just that: In the eyes of the law, it creates a clear separation between business and personal assets. It’s a metaphorical wall between your personal life and business life.
If a court determines that you must pay damages, only your business assets would be at stake. Legally, claimants and/or creditors cannot go after your personal assets.
Say a tenant decided to sue for an accident in your rental unit. If the rental is registered as an LLC, the maximum they could sue you for are the assets held in the LLC (worst-case scenario, that includes the value of the rental property). But they cannot then also go after your personal savings, car, etc. The liability is limited by the size of your business.
This, of course, doesn’t mean that setting up an LLC protects you from the possibility of lawsuits—the meaning of “Limited Liability” is sometimes misunderstood in this way. All it means is that your liability stops at your business assets; the business can still be sued, and, if the claimant has a case, they can win.
Common Mistakes First-Timers Make
If you have already bought your first investment property (the traditional route with a mortgage, not cash buyer) and are now reading this and thinking, “great! Now I’ll form an LLC!” you need to tread very carefully.
Forming an LLC after closing on a property technically triggers what’s called the “Due on Sale” clause, where the mortgage lender can demand full loan repayment due on the transfer of ownership. Your lender may not do this, but they certainly can. You should always form an LLC before you close and sign the deeds on the rental property.
Having said that, there still are ways to incorporate the property into an LLC, but it will need to go through a land trust first. If you already own property and want it to become part of an LLC, you’ll need legal advice first.
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Newbie investors often dislike the administrative work (especially come tax filing time!) of running a separate LLC, so they sometimes incorporate multiple properties into one LLC. This can seem like an efficient way of running things, but it is a mistake from a legal standpoint. If a lawsuit does happen and all your properties are part of the same LLCs, they are now all on the line. You should always isolate the liabilities for multiple properties, incorporating each into its own LLC.
Another common mistake first-timers make with LLCs is that they don’t keep personal and business finances separate. This is known as “piercing the corporate veil” and essentially negates any protection offered by the LLC. If, for example, during a lawsuit, it’s discovered that you were using your LLC bank account for personal expenses, the court can determine that you can still be held personally responsible.
Finally, holding rental property in an LLC can place restrictions on financing future properties. Fannie Mac and Freddie Mac, for example, will not lend to LLCs, so if you want to finance an investment property through them, you’ll have to do it in your own name.
Final Thoughts
LLCs are not a panacea, but for most investors, they do offer very real asset protections and are well worth the extra time, paperwork, and small fees involved.
If you want to make sure your rental investment LLC is set up correctly from the get-go, get in touch with us at LegalZoom. We can help with everything from timing the formation of your LLC to paperwork and any individual complexities of your real estate business.
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