The Most Important Real Estate Investing Decision (Aside from Selecting Properties)
When starting to build a real estate investment portfolio, one of the most important decisions you’ll make (besides selecting the right properties) is how to protect your assets from liability.
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There are risks involved in owning real estate, and the risk of liability is probably one of the scariest. Fortunately, there are several safeguards available to help you protect your assets and limit your liability.
Deciding which option is best for you depends on your goals, tolerance for risk, current needs, and future intentions.
Risk of Liability
Even for the most conscientious real estate investor, the risk of liability exists. You can be diligent about inspecting your property and making repairs as soon as the need arises, but unknown risks can still be present.
Most liability lawsuits are due to accidents, which of course you can’t anticipate. If an accident happens at one of your properties and someone believes you may be liable for damages or injuries that occurred, a lawsuit will likely follow. Covering property damages is one thing, but if the lawsuit includes personal injury, you could be sued to cover medical bills, loss of income, and more—which can add up fast.
So, what can real estate investors do to protect their assets and limit liability exposure? There a several commonly used approaches and a couple unconventional methods.
It can be helpful to think of protecting your assets and limiting your liability in terms of a pyramid or layering of safeguards. When you first start out, a single safeguard may be adequate. But as your portfolio grows, it is likely you will want additional protections added in. Below are some of the more common approaches to safeguarding your assets, including advantages and disadvantages to each.
Common Approaches to Asset Protection and Limiting Liability
The first step in protecting assets and limiting liability for most real estate investors is insurance. When it comes to deciding on liability insurance, key factors to consider tend to be your tolerance for risk (what you are willing to lose) and the cost to limit your liability.
Insurance can get expensive. It can feel like you are throwing money away if you have been paying in for years without making a claim.
But what if an accident did happen and you were found liable?
On the flip side, it is important to keep in mind that having a liability policy in place does not necessarily give you fool-proof protection. Liability policies typically have limits, exceptions, and carve-outs. While the chances that you will be hit with a settlement award that exceeds policy limits is remote, if it does happen, the outcome can be devastating.
If you have a high tolerance for risk, a typical liability policy may be all you need. As your portfolio grows, it may make sense to increase liability insurance coverage, add an umbrella policy, and consider one or more of the other options discussed below.
One step real estate investors can take to protect assets and limit liability is to create anonymity when it comes to property ownership. This can be accomplished by establishing an anonymous or land trust.
A trust provides anonymity and protection by concealing your identity, helping to keep your net worth out of public record and obscured from lawyers.
Probably the most common way to protect real estate (behind insurance) is setting up a limited liability corporation (LLC). Think about LLCs as a separation of assets or compartmentalization.
Setting up an LLC for each property creates a boundary between your assets. When a property is held in an LLC, lawsuits or judgments can only be made against the property in the LLC. This becomes especially important as your portfolio grows.
If you directly invest in properties, all your assets would be subject to any settlement awards. In a worst-case scenario, you could lose everything.
In contrast, if you use an LLC to invest in a property, only the assets owned by that LLC would be subjected to any judgments.
But for many real estate investors (especially those with large portfolios), the trouble of forming and maintaining multiple LLCs isn’t worth protection from the theoretical threat of a lawsuit—particularly when affordable liability insurance is available. Alternatively, consider a Nevada or Delaware Series LLC, which is designed to protect each property within a single LLC.
The moral of the story is, even if you don’t set up a separate LLC for each individual property, it is probably still a good idea to form at least one to hold all of your properties as a means of keeping them separate from your personal assets.
Not-So-Common Approaches to Asset Protection and Limiting Liability
The above safeguards are some of the most commonly used. Strategic implementation of one or more can provide you with a good level of protection. Many investors will stop there, but if you are looking for an additional layer, you might also look toward one of these less traditional tactics.
Another layer of protection can be achieved by borrowing against the asset. This approach, commonly known as equity stripping, gives a third party a lien against the equity.
There are a variety of ways to do this. The most common method is to strip the equity via a home equity line of credit (HELOC). Even if the HELOC remains unfunded, it will serve to reduce the on-the-books equity in the property.
Another option, one that’s admittedly controversial, is the self-insured approach. Warning: this is only for those with a high tolerance for risk.
Some investors who have built a large portfolio and created significant wealth are willing to roll the dice. They keep the property in their name, do not hold properties in any LLCs or corporations, and have only basic insurance on individual properties.
They believe the theoretical risk of a liability claim is low, and they are willing to be exposed in exchange for lower insurance payments, reduced paperwork, and what they believe to be fewer headaches.
As you can see, there are many options. Choose the one that is best for you based on your needs and future intentions. And again, always consult your legal and tax professionals.
Which methods of protection have you used? Which are you considering?