Insurance or LLC?

Question

In Podcast # 109, Scott talked about the limitation of insurance policies. Basically, from what I understood, the interest of your insurance company does not necessarily align with the landlord's. So when a claim is filed, the insurance company will look for ways to not cover the expenses. So... I've cut a few corners like leasing out my primary residence and subletting... I'm afraid my current insurance policy will not cover me if anything happens. Then should I creating an LLC to protect my other assets? LLC is expensive in California, so I'm going back and forth between getting additional coverage or an LLC... Any advice?

Mark B. · Answer

@Fay Chen If you have a loan on the property that assumes that the dwelling is owner occupied then that is technically a separate issue from the insurance. Typically you need to occupy the property for the first year or they can call the loan (make you pay it back now). If they really want to get nasty they could come after you for mortgage fraud. I wouldn't be confident that if you made it through the first year without being caught then you are home free.

If something goes wrong the insurance company is going to start to ask questions, as they should. They will in all likelihood find out that you don't live there and then you will not have coverage, which begs the question, why have insurance that you can't use? If you live there and rent rooms just tell them that, in writing, to make sure that you have the correct policy. BTW - your mortgage company may very well find out and will especially take notice if it is rental only policy.

About the friend that is your property manager - are they a licensed real estate agent or are they on title with you? In CA at least your friend and possibly you could get in a heap of trouble if they aren't an agent or have an ownership interest.

I see from your profile that you want to make real estate part of your life long term - correcting all of the above will cost some cash short term, but not correcting the above will be a significant drag on your income long term if anything goes sideways. Kind of like earthquakes, at some point, things go sideways.

Account Closed · Answer

You sort of need both...

Regarding the other issues.. the insurance company may offer to cover a range of issues that might address the concern of most rental property owners but usually that may often mean higher premiums and may lower the property's net cash flow.

It is not unusual that the insurance company would try to find various ways to either not pay (or underpay) when a claim is filed. Insurance companies are businesses too, so paying liabilities is a business expense that doesn't make the income statement look too good.

The property renting business does have its risk. There are tons of ways that a liability may arise and that may exceed a policy coverage limit. This is where your assets and any equity in the rental property (properties) could then be a target by whoever is suing you. This is also where the LLC as an asset protection device comes in.

Regarding LLCs, some states could comparatively be 'costlier' to set up and maintain an LLC in. There are also yearly maintenance costs involved, which does also vary. The level of protection that an LLC is able to provide does have a way of varying in most of the states also -- especially if it is a single member LLC compared to a multi member LLC.

Wyoming and Nevada have some of the best asset protection features. If cost is purely the issue, there are at least 8 to 11 states where an LLC could be set up at a lower cost than that of California for instance but they may not offer a similar protection or other benefits as in Wyoming and Nevada. Be aware though that the initial filing cost does not necessarily reflect the yearly recurring filing and maintenance cost.

It is not unusual to set up an LLC outside of where you reside and then operate as a foreign entity there or elsewhere; you would have to then do the math to see if there is a cost benefit to such an approach when you factor in any local filing requirements and yearly fees that may be necessary based on the exact nature and classification of your activities by the state.

So you sort of need both the insurance & LLC. Just one might not be sufficient. There are too many stories of 'I wish I had done this or that' on here regarding this issue.

Fay Chen · Answer

@Rob Beland, I think that's exactly what I need to do. I was afraid to do that from the beginning because my loan was owner-occupied. Fortunately nothing happened. I think I was lucky.

@Steve Vaughan, I'm only one month away. So I'm going to call my insurance company soon. What did you end up doing with your property? Did you get in trouble with the mortgage company?

Rob Beland · Answer

@Fay Chenwhat you are doing is considered fraud and its illegal. It doesn't matter whether you have insurance or you set up an LLC. You're trying to justify and defend the fact that you have a standard homeowner's policy when you aren't living in the property. If one of your tenants gets hurt you should expect a lawsuit and your insurance company won't defend you. You can set up an LLC or an S-Corp or any other entity. You won't be protected. You need to convert your policy to a fire/dwelling policy as a non-owner occupant and get some liability insurance.

Steve Vaughan · Answer

@Fay Chen I may have faced this same dilemma early on. I didn't rent out rooms, but converted to a rental before EOY1. But I did intend to occupy the property!

How close are you to that year mark?  If close, I would sit tight.  If far, fess up and sell if you have to.  I hated waiting in hopes nothing happened to the house.  I hope this works out ok for you!

Mark B. · Answer

@Fay Chen  To make it all work the way you have it setup you need to physically live there. When something goes sideways and the people who live there start talking and have to sign a form that says, "under penalty of perjury..." they aren't going to say you live there.

Since the friend doesn't have a broker they probably can't manage the property, legally. Perhaps you could ask them about refinancing the property into a non-owner occupied loan?

Regardless of the LLC, I would get an umbrella.

“If you tell the truth, you don't have to remember anything.”

― Mark Twain

Kyle J. · Answer

Hey Fay,

Your question is a good one and, since I'm also from California, I totally get what you're saying about the high cost of setting up/maintaining a LLC.  (We're actually the highest in the country.)

Plus, with a LLC, it's also possible that you could run into problems with your lender when you try to transfer the title to your property into the LLC name.

Personally, I've chosen to go with a good insurance policy AND an umbrella policy that can cover not only your rental but all of your other assets as well.  An umbrella policy is also very inexpensive for the amount of coverage you get.

Anyway, here's a blog post on this exact subject that may be helpful:  Should You Put Your Rental Properties in an LLC?

Steve Vaughan · Answer

@Fay Chen as soon as my year was up I called the insurance co and stated it is now a rental and I will need to change my coverage to a landlord policy. That was 2004 and I still have the house.

I didn't get into trouble from the mortgage co in my particular situation, but I wouldn't do it again. I'm sure you won't, either. You'll probably get a renewal notice or offer from your insurer about 2 weeks before the year is up.  At that time I would talk to them about converting to a landlord policy.  Some co's want your primary home or your cars also to carry a LL policy.  See what they need and shop if necessary.  You're almost there!

Fay Chen · Answer

@Cam Coplin, thank you for the insight. Actually, my friend manages the property for me. But I didn't know that was a requirement. It will limit what I can do in the future, and the LLC will just be a very expensive insurance policy... While it still remains an option for the future, I'll do more research on insurance policies for now. Thank you!

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