2 Entity Structures That Are 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.
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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:
- Sole Proprietorship
- 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.
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.