12. Asset Protection
Should you form an LLC to hold your property or properties? Or should you just rely on the liability portion of your insurance policy and order an umbrella insurance policy? If you look at online forums there are as many answers as there are people offering their advice. Most of those people aren’t attorneys. We aren’t either and nothing in this episode should be construed as legal advice. But we know people who specialize in this field and pay for their services. Here’s our take on this common topic among investors:
If you have assets or if you even look like you have assets you’re a juicy target for getting sued. Whether a lawyer takes a case against you depends on whether they can find assets to take away from you. If you want to avoid being a target then don’t have any assets in your name. Or have really bad credit. Apparently that works too. The very wealthy have a lot of assets. But they don’t own them. They just control them. That’s the key here.
You’ll probably get sued eventually if you stay in this business long enough. Whether it’s from a tenant slip-and-fall on your property, or if a property sale went south and the other party is upset. If you want to make real estate an enduring part of your investing strategy, you should prepare yourself for the possibility of this happening. You can do so by educating yourself about how to protect your assets so you’re not caught with your shorts down.
The most basic form of liability protection is insurance. If your tenant slips and falls and sues you there should be some basic liability coverage on your property insurance. You can also purchase commercial general liability insurance if you have an LLC . If you own your properties in your own name you can buy umbrella insurance, which is pretty cheap for 1 million dollars of coverage. However, be warned. Insurance companies are businesses and if they can avoid paying out they will! So don’t count completely on them to cover your butt if you get sued!
But what about trusts? These are generally cheaper than LLCs and don’t generate the hefty accounting bill every year. There are many types of trusts out there. Your typical living trust will only keep the assets inside the trust out of probate court when you die. But if you have a house in the trust then everyone can find out who owns the house. If you have a land trust then you can hide the true owner of the property from the public. Land trusts are great for anonymity but they won’t provide any liability protection for you if a tenant sues you from the property owned by the trust.
For real asset protection, you want the LLC. As long as you operate the LLC like it’s a business you’ll be able to compartmentalize your assets from your personal name. Let’s look at two examples:
Example 1: Attacks from outside the entity. Let’s say you get in a car accident. The other driver sues you in court. If they get a judgment against you then every asset you have in your name can be seized by the other party in the lawsuit. This includes your personal residence, stock portfolio, and antique teacup collection. Your LLC should remain intact if you operate it correctly. Ideally, since the property is inside in the LLC they shouldn’t be able to take it away from you.
Example 2: Attacks from inside your LLC. Your Tenant slips and falls and sues you. Any asset inside the entity that owned the property your tenant fell in is fair game in a lawsuit. If you have multiple properties in one LLC then all those are fair game to seize. If you only have one property in that LLC, then all the tenant can try to go after is the one property. Nothing else you own, like your antique teacup collection, is fair game in that lawsuit as long as you operated your LLC correctly.
Now, let’s talk about another way to protect your real estate assets. It’s not widely known, but it actually makes perfect sense. Debt. Yes, the leverage you have on your properties acts as a form of liability protection. Think about it. Lets say you own a five hundred thousand dollar property and owe five hundred thousand dollars on it. What would someone get if they sued you? Well, they couldn’t sell that property and make a profit because they would have to pay off the mortgage first. Also, it costs money to sell property and then there’s capital gains taxes involved. Sure, they could operate that property and hope to cash flow it. But no lawyer is going to make money off seizing that asset from you so why would they try? Now, imagine a five hundred thousand dollar property owned in cash. Do you see how it’s a giant target? All the plaintiff has to do is gain control of the property, sell it, and walk away with hundreds of thousands of dollars. Savvy investors know this technique as “equity stripping” and utilize debt to move equity from one asset to another.
This is a very condensed version of a very large and important topic. If you’re interested in putting any of these concepts to use then seek out lawyer who specializes in asset protection. While many lawyers can draw up an LLC or trust, you want one that specializes in real estate or asset protection.
I know the content of this episode may sound alarmist. We’re just encouraging you to be a good boy scout and be prepared. If you currently own rental property in your personal name at least go out and purchase an umbrella insurance policy while you consider a more sophisticated asset protection strategy.