Why do People Create LLCs?
If you own a rental property, it is strongly advised that you create an LLC. I’m going to give you 3 reasons why, but before that a few introductory remarks in general about who I am and why you should listen to me.
I have personally sued property owners and have won.
Unlike many estate planning attorneys who can only tell you about the theoretical risks, I spent over a decade of my career working in the courtroom as a litigator. Before I went into private practice, I worked as a trial lawyer at a plaintiff’s law firm. For those of you who don’t understand what this means, in litigation, there are two kinds of lawyers — plaintiff lawyers and defense lawyers. I specialized in suing people, and among the $35 million of judgments I recovered, a fair amount of the people I sued were property owners.
So I can tell you all about lawsuits because I worked for the other side. I know the in’s and out’s of how a plaintiff lawyer thinks, because I was one. I’ve seen first-hand how people lose their fortunes because they were “a penny wise and a pound foolish.”
One thing that you need to understand as a property owner is this: no one cares if you are right or wrong. The reality is that litigation is expensive. If you get sued as a landlord, it is faster, cheaper, easier, and safer to pay money to end the lawsuit than it is to fight and prove you are right. Litigation is very expensive. You can easily pay $50,000 in attorney’s fees, if not more, just to get to a trial. You will spend years litigating the case. Your insurance will go up. If you lose, you will stand to lose far more money than attorney’s fees. I’m not exaggerating. Keep reading and you’ll see what I mean when I share real-life stories that every property owner needs to know.
I have rental properties of my own.
I am not just a lawyer speaking in hypotheticals. I am a real estate investor myself. I come from a family of real estate investors as well. I have intimate knowledge when it comes to how rentals play out in real life.
Therefore, I assure you that everything I am saying to you is what I practice myself.
If $800 is too much, you should get out of the game now.
To maintain an LLC in California, it costs $800 a year. If you think that’s expensive, you need to stop reading this article right now, sell your property, and get out from the rental business. I know that sounds harsh, but I am doing you a favor.
The reality is that $800 is a pittance compared to the tragedies that can unfold if you are sued and unprepared. Even if you own a single family rental home or more, you will regret not having paid $800 in order to protect your net worth.
6 Real-Life Stories.
Notice that in each of these examples below, the property owner was blamed regardless of who was truly to blame.
Incident #1 – Two men start arguing. One man goes home, gets a gun, and comes back to the apartment complex. He walks in through a gate that is unlocked. He shoots and kills the apartment resident. The family of the deceased resident sues the property owner for negligence because the lock on the gate was broken and this allowed the shooter to enter the premises. The jury found against the apartment owner and awarded millions of dollars in damages.
Incident #2 – A tenant was cooking in his home when the stove suddenly exploded, burning the resident severely. The man sued the apartment owner for negligence, claiming the stove should have been in proper condition, and was awarded millions of dollars.
Incident #3 – A tenant’s dog bit a neighbor, causing lacerations and severe injuries. The neighbor sued the property owner of the home (not the tenant) — and won.
Incident #4 – A man was making methamphetamine in the room he was renting. A chemical explosion caused the man’s unit to burn down along with those belonging to neighboring residents. A lawsuit on behalf of all injured residents was filed against the landlord, resulting in millions of dollars in recovery.
Incident #5 – A resident’s two-year old child began biting the window sill, ingesting paint chips with a high amount of lead. After the child was diagnosed with lead poisoning, the man sued the property owner — and won millions of dollars.
Incident #6 — A tree located on the sidewalk of a residence fell and injured an individual. The property owner, who neither planted the tree nor maintained it, was sued – and the jury awarded a sizable verdict.
Do you think any of the property owners in the cases above wished that they would have spent $800 to protect themselves from these lawsuits?
So yes, you should create an LLC. Here’s the 3 main reasons why.
1. An LLC Protects your Personal Assets.
A limited liability company (LLC) is a legal entity that you create for the purpose of owning your rental property. If the LLC, instead of you, owns your rental property, then any lawsuit involving the property must be directed at your LLC — not you! Therefore, this protects your personal assets because the person suing the LLC can only recover whatever your LLC owns — not what you own.
If your LLC owns one rental property, then the person suing can only recover that one property. If your LLC owns more than one property, then the person suing can recover all the properties owned by that LLC. Thus, it’s in your best interest to create multiple LLCs to own multiple real estate properties.
One important thing to note. Pay more money and get a lawyer to set up your LLC the right way. Many people resort to DIY online planning when creating their LLCs or try to save money by having someone other than a lawyer prepare their legal documents. This is a big mistake in my opinion, because more often than not, these LLCs don’t hold water when the time comes. I’ve seen LLCs that were set up in the wrong state, or LLCs that were set up owning certain kinds of businesses that state law prohibited the LLC from owning, or operating agreements that lacked key provisions that needed to be included at the outset.
Assuming you have a properly-established LLC, you can sleep peacefully knowing that your personal assets are safeguarded.
2. Umbrella Insurance is for a Rainy Day, the LLC is for a Sunny One.
Read my lips: umbrella insurance is not enough, but you still need it, so get it.
Umbrella insurance is designed to sit on top of your underlying insurance policy. For example, if your policy covers $100,000/$300,000 of coverage, and if you have umbrella coverage, it means you are now covered up to $1 million, or whatever the value is of your umbrella.
If you get sued and the umbrella insurance covers your claim, it will be the best money you spent. The umbrella will not only cover the judgment (up to your policy limit), but the insurance company will also hire an attorney to defend you and they will pay for the legal bills, which will not be inexpensive.
But if you get sued and the umbrella insurance does not cover your claim, having the LLC in place is the smartest money you would have spent. Yes, you will end up having to pay the legal bills yourself, but your personal assets are beyond the reach of your creditors.
Therefore, insurance is good, but it does not cover every claim out there. Here’s a list of potential claims that can arise in one lawsuit:
- Housing and disability claims
- Discrimination lawsuits
- Property management torts
- Toxic Mold
- Covid 19
- Assault & Battery on Premises
- Premises Liability (including failure to maintain/ sidewalk repair / tree fall cases)
- Product Liability (Faulty equipment / explosions)
- Negligent Hiring/Firing
- Breach of Contract
- Failure to Disclose/Fraud
- Failure to Evict
- Dog Bite
- Animal Damage
- Partnership Disputes
- Loan Default
- Personal Injury and Wrongful Death
- Faulty Repair
- Worker’s Compensation
There’s a saying, “What the large print giveth, the small print taketh away.” This means that you should read your insurance policy carefully. Unfortunately, most probably throw away their policy, because it looks like junk mail (it’s the booklet that gets mailed to you only a few weeks after you’ve already bought the policy). It contains tiny writing that lists out all the various exclusions and items that your policy will not cover if you get sued. Would have been nice to see this before purchasing the policy, right?
So, in many of these cases, insurance does not, and will not, cover the claim. So if you don’t have an LLC, what’s your plan B?
As I say to our clients, umbrella insurance should be your first line of defense. Your LLC is your second line of defense.
3. LLCs Play Nicely with Taxes, Trusts, and Creditor Claims
LLCs in general offer good flexibility regarding collateral issues.
For example, compared to corporations, LLCs offer better asset protection when it comes to charging order protection and protecting from both inside and outside liabilities. If you are driving a car and injure someone, or if one of your tenants sues from within the LLC, either way the LLC offers greater protection than a corporation would.
LLCs also offer plenty of options within taxation structures which, in turn, allow for tax savings. I can own an LLC and yet choose to tax it as a partnership, as a disregarded entity, as an S Corporation, or even as a C Corporation. LLCs qualify for step-up in basis if I select the §754 election as well. So there’s room to operate for most, if not all, your needs from within the framework of the LLC.
Finally, LLCs and trusts work quite well together. If you have a trust, the LLC should be funded into the trust (assuming the Operating Agreement permits such transfers; most DIY operating agreements do not). In general, an LLC is like a puzzle piece, just as your trust is a piece of the puzzle too. Both fit nicely together in creating good asset protection and tax saving strategies in the long-run. Moreover, your lease agreements and rent payments should be assigned to the LLC, which will stay the same even after you are gone.
The LLC is one of the single, most effective ways to hold real estate property and still protect your personal assets. Not having your rental property in an LLC is like having a target on your back. It’s just a matter of time until you’re hit.