Follow Us on Social Media

email icon rss icon linked.in icon google plus icon twitter icon facebook icon

2 Entity Structures That Are Not Wise for Real Estate

by Amanda Han on March 27, 2014 · 24 comments

  
Two Entities Not Wise for Real Estate

Americans, unfortunately, face a high likelihood that they will be sued at least once in their lifetime. If you are a real estate investor you have an even greater chance. The more you grow your investment portfolio the greater your risk for an accident. To protect yourself you need to be sure that insurance is a key part of your plan. There are other areas that should not be overlooked like missed payments, insurance policy lapse or denied coverage. If these things are not considered then it can easily affect you personally. This can mean that everything you personally own can be at risk. No amount of tax savings and economic benefits can protect you from losing your assets. Hopefully not all of your assets like for some unfortunate cases.

Having protection for your assets also protects you personally against your assets. Sounds confusing? Okay let’s give an example. If you accidentally injure someone or get sued for some reason then your personal assets can become at risk. So the major benefit of having a limited liability company or limited partnership, is that your real estate portfolio is protected in most states by law from creditors.  It’s important to keep in mind that if you hold all your real estate in your personal name or in a different type of entity then they are not as protected.

When it comes to holding real estate there are..

Two Entity Structures That Are Not Wise to Use:

  1. Sole Proprietorship
  2. General Partnerships

These are the two structures that are not considered legal. A Sole Proprietorship is viewed as an extension on yourself. A General Partnership is not any better because it is viewed as not only an extension of yourself but also an extension of any partner you have in the business. This means you BOTH are responsible for each other’s actions.

An Example of How These 2 Entity Structures Can Cost You Big Time:

Susan and Michael are successful real estate investors and focus on investing in apartments that they hold in a general partnership. They set this up because at the time it was easy to form and they didn’t need to hire a lawyer or an entity formation service.

The apartment building they purchased was in good shape and was in a decent neighborhood. They were very hands on for the maintenance so it was very common to see them visiting the property and tenants often. They did not have any tenants that gave them problems so for the most part you can say they were the lucky property owners that we all want to be. They definitely heard their fair share of horror stories from other fellow investors, so they felt very fortunate.

Unfortunately for Susan and Michael, their luck was about to run out. One day a tenant was in a car accident and sustained very bad injures. As a result, they had to use crutches to get around. Then it happened… an investor’s worst nightmare, the tenant fell in the parking lot. This fall broke more bones for this already injured tenant.

As soon as Susan and Michael heard about this tenant’s accident, they decided they would stop by and bring a nice get-well basket. Unfortunately, on that same afternoon, Susan and Michael were informed that they were being sued by the tenant for his recent fall in the parking lot.

This presented Susan and Michael with a huge dilemma! The apartment building was held in a general partnership remember so this means not only is the apartment building itself at risk, but so are Susan and Michael’s personal assets such as their primary home, their money, and any other investments. They all become fair game in a situation like this. Before they knew it, they were spending tens of thousands of dollars in legal fees trying to resolve this issue.

Even though Susan and Michael had the right idea to put asset protection in place, the way they executed their asset protection plan was far from perfect. If you start with a properly protected business structure then it is easier to separate assets using business structures. In the case of Susan and Michael, the wrong business structure cost them severely.

Related: Will Your Real Estate Asset Protection Stand up in a Fight

Conclusion

Had Susan and Michael worked with a knowledgeable advisory team, they would have suggested a better plan. Their investment property may have been held in either a Limited Liability Company or a Limited Partnership. They may have also suggested equity stripping strategies to make them appear less attractive to a potential tenant looking to sue them. In the end, less of their personal assets would be at risk and they would be less appealing for a potential creditor to sue.

Asset protection in reality can be looked at as a type of insurance. You get it in the good times to protect yourself from the consequences of bad times. Putting asset protection into place before any issues arise is essential because once someone has threatened you with a lawsuit, it may be too late. If you don’t have the right entity structure in place for your investments, you may be risking everything you have just as Susan and Michael did. So take the time to protect your wealth by appropriately structuring your entity.

Email *
  



{ 24 comments… read them below or add one }

Jeff Brown March 27, 2014 at 4:58 pm

Good stuff as usual, Amanda. In your view, would moving the ownership of the property from their names to say, an LLC, violate any part of the note contract? Thanks, and much appreciated.

Reply

Amanda Han March 28, 2014 at 9:25 am

Hi Jeff. Good to hear from you and that is a great question. The answer will depend on the note itself. It is my understanding that most lenders “can” call a note due when you change ownership however in my years of experience I have yet to ever personally (or any of my clients) have that happen when a lender calls a note due as a result of ownership transfer into an entity. So yes it is possible, but practically speaking I have not seen that happen.

Reply

Leonid March 27, 2014 at 6:44 pm

Amanda,
I love your commentary.
With regards to your example though .. doe it make sense to pay 800.00 minimum tax for LLC, when it may or may not cover the incident you have described.
.. If the cause of the accident is owner/manager negligence, it appears that Owner/Manager will be personally liable .. thus LLC will not be much help.

It may help if the owner has a Property Management co. with liability insurance, but this would probably work without LLC overhead as well.

I own properties as a sole proprietorship, each property policy has liability insurance plus I bought Umbrella policy that will cover excess .. Let me know if my train of thought off is off the truck .. :-)

Reply

Amanda Han March 28, 2014 at 9:28 am

Hi Leonid: Great comment and yes, if an owner does something to cause this to then I feel the entity itself may not be fail proof either. A lot of it unfortunately will also depend on who your attorney is cs the other side too. Of course, having more protection is generally better than less protection. So yes it is great that you have the insurance policies and umbrella on top of that. With respect to the umbrella just make sure you get a list of exclusions on this policy and confirm rental RE is not on there as an excluded asset as this happened to me several years ago. If it is excluded you can just add a rider to the policy to include the rentals.

Reply

Sharon Tzib March 28, 2014 at 9:36 am

That I did not know, Amanda (about umbrellas excluding rentals). I wonder how many others don’t too. Great tidbit!

Reply

Marta March 27, 2014 at 7:55 pm

Hi Amanda,
I am happy I came across your post. I will be reading all of your posts today as whether or not to register an LLC was my big issue today… Gave me a bit anxiety. Hopefully your posts will explain a bit more ..

Thanks
Marta

Reply

Amanda Han March 28, 2014 at 9:30 am

Hi Marta: If you have any LLC then you should check with the state on registration requirements as each state is different. The main thing is that if you formed an LLC, make sure you connect with your CPA and attorney on the correct way to use the entity to ensure you get the most tax savings and asset protection. One of the most common mistakes I see is that people form an entity and then forget to use it for its intended purposes.

Reply

John March 28, 2014 at 12:07 am

Actually here I get some useful information about real estate business properties and also take a look other community blog. That’s awesome :) my sense already clear that how can I get a property for living life better :)

Reply

Amanda Han March 28, 2014 at 9:31 am

Thanks John. Love the little happy faces on an article about lawsuits….haaha.

Reply

Sara Cunningham March 28, 2014 at 2:59 am

Great post Amanda. So if I am reading this correctly having property registered under an LLC and carrying insurance with a liability clause will protect you, right? Or is there something else like an umbrella policy that you also need? I have the first two but not an umbrella policy, what would be the benefit of adding this?

Reply

Amanda Han March 28, 2014 at 9:33 am

Hi Sara: Unfortunately there is nothing that is 100% fail proof but yes ,having an entity and using it correctly, having insurance, and operating your real estate the right way would go a long way to help you minimize risks. Umbrella insurance policy is a great added benefit as long as you confirm that your policy does not specifically exclude rentals as some policies specifically exclude those.

Reply

Paul Salmela March 28, 2014 at 7:56 am

If Susan and Michael had liability insurance (which is pretty standard) wouldn’t this have been a better plan to protect this asset? If they didn’t have any liability insurance the tenant could have sued them for the equity they had in the apt building. On top of the standard liability insurance I also have a several million dollar umbrella insurance which is about $500/year. To me this would be the best protection.

Reply

Amanda Han March 28, 2014 at 9:36 am

Hi Paul: Yes the liability insurance itself is also wonderful as well. Each person has a different risk tolerance level and some people like to have protection on top of protection on top of protection while others have properties with little risk. Its important to discuss this with your attorney on whether the insurance policies are sufficient for your situation based on the property and your personal assets. I love the umbrella insurance policy myself as well because as you indicated, it is a cheap way to get insurance coverage over not just your RE but also other assets you own. Thanks for the comment!

Reply

Sharon Tzib March 28, 2014 at 9:27 am

I’m a big fan of using a combination of insurance and umbrella policies if you are not of a high net worth, but I believe once you enter the realm of apartment investing, you must treat the asset as a larger liability and title it into an LLC (and as Jeff states, make sure your lender won’t have an issue with that). Some people look for assets not in LLC’s as targets for filing suit, so just having one will put some people off.

What people need to understand, however, is that just titling your asset into an LLC is not enough. You must set up a bank account, fund that bank account with an amount of money that is reasonable for conducting business for that asset, and then only use the funds for that asset – comingling your personal funds w/ the LLC’s funds are a big no-no. You also have annual obligations, like shareholder’s meetings with minutes and filing taxes, that you must perform. Any failure to do any of these things could leave you vulnerable to being held personally liable in a lawsuit situation.

You can’t just title your property into an LLC and think you’re free and clear. There’s a lot more to it than that, as I’m sure you know Amanda :) Nice article.

Reply

Amanda Han March 28, 2014 at 9:37 am

Love the comment Sharon! I wrote something about this a few weeks ago because I see this mistake all the time when people form entities but then not use it correctly or never transfer property into it so then we have properties still in our personal names and then a bunch of shell companies sitting idle. Great post!

Reply

Sharon Tzib March 28, 2014 at 9:39 am

I can’t imagine spending all that money to create an LLC and then not titling the asset into it. That stuff just doesn’t magically happen haha! Thanks Amanda!

Reply

Jeff Brown March 28, 2014 at 10:15 am

Amanda has likely rescued countless investors when it comes to umbrella policies and their exclusions. The first one I ever obtained excluded rentals. I didn’t know it for almost a year. This is WAY back in the day. Dad passed the bar, and decided to read every contract either one of us ever signed that wasn’t a purchase or exchange contract.

He was beyond livid. :)

Reply

Deanna March 29, 2014 at 7:29 pm

Wow. Go Dad!

Reply

Leonid March 29, 2014 at 12:00 am

Yes, Indeed .. exclusions is something I was not aware off .. Amanda, you just created a drug free sleeping pill,- re-reading my umbrella policy .. Whoever makes Ambient will not be happy with you :-)

Reply

Amanda Han March 29, 2014 at 2:56 pm

Thanks for the comment Leonid. Actually for my policy with AAA it was just one or two pages with a listing of the exclusions so it may not be as bad as you think =)

Reply

Jimmy Moncrief March 29, 2014 at 8:23 pm

Great post Amanda! I’ve never thought about it like this before.

Reply

Kirsten Walstedt March 30, 2014 at 1:35 am

Hi Amanda, great article! Someone on one of the messageboards here said that an S Corp with a sub-corporation for every property is better than an LLC. I have my one property in an LLC right now and hope to add a second one soon. Should I change to an S Corp and create a sub-corp for each property? How much would that cost? Thank you!

Reply

Rob March 30, 2014 at 10:56 am

I had the same question around S-Corp. I’m in Texas and want to confirm that we have the same liability and asset protection if the property are held in a S-Corp.

Reply

Shaun March 30, 2014 at 2:58 pm

I think you get just ad much protection with an S Corporation (with more work to do that than an LLC).
The issue I’ve always heard is the taxation for rental real estate is very unfavorable for a corporation (S and C).
Amanda can definitely clarify this point.

Reply

Leave a Comment

Comment Policy:

• Use your real name and only your name in the field designated for your name.
• No keywords allowed as anchor text in the name or comment fields.
• No signature links allowed under your comments
• You may use links in the body of your comment, but it must be relevant to the discussion at hand, and not merely be some promotional link.
• We will have NO reservations about deleting your content if we feel you are posting merely to get a link without adding value to our discussion.
If you add value, but still post keywords, we'll use your comment, but remove your link and keywords.
• For more information about acceptable practice, see our site rules.

Want your photo to appear next to your comments? Set up your Gravatar today.

Previous post:

Next post: