LLCs: Asset Protection for Real Estate Investment.

Beware of the risks of owning assets under your name.

With the swings of the stock market as of late, many of my clients have chosen to diversify into real estate. It kind of makes sense. You buy for example an apartment for a relatively small down payment and your tenant ends up paying for the mortgage and the rest of the expenses. The rent may even leave you some change left. The property pays for itself while its value hopefully goes up in time. The stock market in the meantime can go wherever it pleases.

This certainly is a legitimate investment strategy proven successful to many. Of course, there are a number of preconditions, starting with making sure the property is always rented, or that nothing major breaks down. But equally critical, is to make sure the property is properly shielded against legal exposure. Let me explain.

Let's say one of the kitchen cabinets was improperly mounted long before you bought the property. Of course you had no idea about this. While your tenant loads the cabinet with her china, the whole thing goes down. The incident leaves her permanently injured. Consider it a fact that she will promptly get legal representation, most likely on a contingency basis.

It turns out that your umbrella policy - if you have one - is insufficient to cover all her injuries (and the lawyer's contingency fee). If your equity in the rental is small and you own not much else, the lawyer will quickly lose interest in your tenant's claim and will likely drop the case or suggest she hires someone else. The opposite is also true. If you happen to own significant assets, they will vigorously go after them, all of them (with a handful of exceptions) either the easy or the hard way. In fact, the more assets you own, the more attractive you will be to lawsuits. What seemed a conservative sensible investment diversification strategy, turned out to be a colossal headache, far worse than sailing the rough waters of the stock market. What could have been done to avoid this outcome? Welcome to asset protection.

Rental properties, like other businesses that produce revenue, are inherently prone to lawsuits. While a slip and fall or a breaking and entering seemingly may not be of one's doing, tenants can often argue that their landlords could have made the floor less slippery and the yard more illuminated. The key question here is where does the buck stop -- or in legal parlance, who the landlord is? If an individual is found responsible for the fault, then anything and everything he or she owns is up for grabs to satisfy the judgment. If, on the other hand, the landlord is a corporate entity such as a limited liability company, then only the assets owned by the LLC are in jeopardy, i.e., the equity in the rental property. This is so even if the LLC is, in turn, wholly owned by the same individual. Hence the importance of titling rental properties under LLCs - not under one's name.

An LLC, however, is not a magic wand that wipes out personal liability regardless. If the investor improperly uses an LLC as his alter ego to escape responsibility, the buck may not stop at the LLC but instead with the investor himself, or in legal parlance again, the tenant can pierce the corporate veil to reach the landlord. This can happen when the LLC is no more than a shell, under-capitalized, and under-insured. Investor's money ends up commingled with the LLC's, there are no corporate documents to speak of, or formalities like annual resolutions. Hence the importance of good corporate practices that include operating and buy/sell agreements, the maintenance of separate books and bank accounts, proper liability insurance for the LLC, and other steps that respect the corporate entity as such.

Those who consider diversifying their investment portfolio with real estate are well advised to incorporate a proper asset protection plan that leverages LLCs, together with other estate planning tools such as revocable trusts and family limited partnerships. If you want to learn more about asset protection strategies, call us at (305) 924-2918 or email us at dcoriat@strategic-a.com.