Should I Form an LLC for my Real Estate Investment?
Is it a good idea to form an LLC for real estate investments, to limit your personal liability? Or, should you hold properties in your own name, and purchase an umbrella insurance policy instead? The topic of forming LLCs for real estate investment has been hotly debated on real estate forums, with little agreement.
Some real estate gurus recommend creating a separate LLC for each property you acquire. Others argue that it’s not worth the cost, paperwork and hassle when liability insurance could provide similar protection. There is also a growing concern that a lender could take issue with an individual who purchases a property and then transfers the title to an LLC. If the lender does not approve of the transaction, they may choose to call the loan due early, which may force the investor into foreclosure.
In this article, we’ll look at all three scenarios briefly, to help you decide whether forming an LLC for your real estate investments is the right choice for you.
What is the benefit of creating LLCs for real estate investment?
Real estate investors are highly vulnerable to lawsuits. A tenant could drown in your apartment complex’s pool. An individual could be injured at one of your rental properties, and sue you for damages. A disgruntled tenant might look for loopholes in your lease. Feeling nervous yet? If so, you may wish to create an LLC for each of your real estate investments. An LLC can protect your personal property from potential lawsuits, limiting your liability to only the assets owned by the LLC. If you own multiple properties, it’s wise to form a separate LLC for each one. In some states, you can simplify the process and paperwork by creating a Series LLC instead. Read more about Series LLCs.
Is it better to get umbrella liability insurance instead?
Umbrella insurance policies can also protect you from lawsuits, and they may be purchased for a relatively low cost. It’s also easier to buy an insurance policy than it is to form an LLC — and it does not involve filing a separate tax return each year. Instead, you simply renew your insurance policy annually, and pay the premiums. However, there are limits to the level of protection your policy will offer, both in dollar amounts and in terms of coverage.
If you have multiple properties, or if you’re faced with a very costly legal scenario, your umbrella policy might not be adequate. Plus, let’s not forget the deductibles, exclusions, and annual renewal costs. If you’re interested in weighing the pros and cons of liability insurance vs. forming an LLC for real estate investment, talk to your attorney, as well as your insurance provider. Ask for several plan options, and request recommendations on the amount and type of coverage that makes the most sense for you, considering the number of properties you own, and the risk level with which you are comfortable.
If you choose to obtain an umbrella policy in lieu of forming an LLC, you will avoid the administrative burdens and initial costs of starting an LLC. In addition, you will gain the benefits of liability protection for lawsuits that arise from your rental properties, as well as your personal property. However, you will only be protected up to the maximum allowable amount in your policy — and, if you read the fine print, you’ll likely find a number of exceptions and disqualifying factors. If you are faced with a loss that exceeds your policy limits, you will be personally liable for the difference.
What about the bank calling the loan due — is that really an issue?
For investors who pay 100% cash for a property, transferring the title to an LLC will not pose a problem. There is also no issue if the LLC is formed first and purchases the property directly (assuming the lender allows this). However, if you finance your real estate property in your name, there is a possibility that the bank could take action on the “due on sale” clause in the loan after you transfer ownership to another party, i.e. your LLC. Many investors simply overlook this potential issue, and encounter no problems. However, it is within your lender’s right to call the loan due, and there have been cases when this has happened.
To avoid this problem, some attorneys suggest creating a land trust, which names you or someone you trust as trustee, and the titleholders to the land as the beneficiary.
Once you establish the land trust, you may then deed your real estate into it, titling your property in the name of the trust. Next, you must assign the beneficial interest in your land trust to the LLC you created for asset protection. Because the trust beneficiary is not a matter of public record, it should not trigger the due on sale clause of your loan.
The bottom line?
For maximum protection, you might consider taking a combination of the steps described above:
- Create an LLC for each property you own (or a Series LLC, if your state allows it).
- If you are taking out a loan in your own name, secure a land trust to facilitate the title transfer.
- If you can afford it, go ahead and secure umbrella liability protection as well. This way, you’ll not only protect your personal assets — you’ll also have insurance to protect your LLC’s assets in the event of a lawsuit.
If this all sounds complicated, we admit that it can be — but protecting your investments (and your personal property) is well worth the effort.