Top 3 Real Estate LLC Myths: Busted!

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I love that show with the geeks that use science to prove of disprove myths. As a card carrying geek myself, it’s fun to watch what is and isn’t true – common perception versus the physics. The same can be seen in the asset protection arena.

The concept of “asset protection” ranks, to me, almost as important as tax planning in our wealth accumulation plan. Bad things do happen that are outside our control, and how we account for the random bad event like a slip and fall accident can make a major difference in our final score in the wealth game. As always, consult your own lawyer before acting on my opinions.

The Unseen Physics that will Come Into Play in this Field are

  1. The desire to encourage risk taking by allowing limited liability. Ever since the British East India Tea Company was formed in 1600 the business alter ego has served a vital part of innovation. If I can set my level of comfort without fear of losing everything – it’s a huge physiological difference, right?
  2. The counter force is most often found in a personal or economic injury cases. If our property was negligently maintained and it resulted in harm justice dictates making the person whole as possible.

So with those to forces acting against each other it begs the question: “Is my asset protection plan effective?” To that end, I wanted to bust the myths associated in this arena. If you take thees into consideration you will be armed and ready for all outcomes.

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1.) I’m Set up with an Entity, Therefore I am Protected

This one is huge. Most people begin with the idea, “Hey, I’ll just got to LegalZoom or RocketLawyer, get my LLC and am I set!” Wrong.

Be it an LLC, C-Corp or S-Corp the same rules apply. The big problem is that we ask the wrong question. “Should I get an LLC” is not the right question – the right question is “will I keep up with the formalities associated with having an LLC?”

Why?

Aggressive and starving plaintiff’s attorneys are going to attempt to use veil piercing. Veil piercing is a judicial tool used to disregard your entity so they plaintiff can get at YOUR personal assets.

It seems silly to waste time with an entity formation and then not follow up with the rules to all most eliminate the possibility of veil piercing. Aside from fraudulent behavior, if you follow these basic rules your entity should be 99% bullet proof:

  • Get insurance and maintain it…not a formal part of the veil piercing framework but it is crucial. Cases where the plaintiff is harmed but has no recovery from insurance results in the invisible hand looking to reach right through your entity. Judges and juries are generally about fairness

Key veil piercing factors:

  • Poorly capitalized entity versus the industry standard
  • Co-mingled funds where you pay business obligations out of personal bank accounts or vice versa
  • Not filing annual reports and filing fee’s

2.) I Don’t Need any Protection Plan

This one is debated often here on BiggerPockets. Many elect NOT to form an entity due to the cost and effort associated. As with anything the cost benefit analysis is always wise, because the amount of equity you start off with real estate investing may make it seem cost inefficient. However to me this is short sighted. Isn’t our goal accumulation of significant wealth through real estate?

So I believe it’s best to set up right at the start, when possible.

3.) I am Set up in a Trust

If anyone asserts that a trust is useful for asset protection become skeptical of why they are saying it. A cottage industry has evolved with this method especially with offshore trust.

They do have some utility in an overall scheme if you employ insurance and or have reserves to pay off a plaintiff. It can be a settlement tool to say, “Hey look, I have a trust” just take the insurance offer.

However, if you are a bad actor, the courts have a lot of tools to compel you to bring those assets to the table for recovery. Complicated layers with LLC’s and offshore trusts are expensive and I am just personally not convinced its worth the effort.

Conclusion

Overall, they are some great ways to use entity to bolster your protection plan. Using a C-Corp as a management entity via a master lease of a property you own in an LLC sounds pretty solid to me.

I am open to learn from your experiences…what do you think?
Photo Credit: zacklur

About Author

Douglas Dowell

Douglas Dowell J.D. is a commercial and multifamily investor. His blog will focus on legally raising private money, risk mitigation with due diligence and management science. He is also an avid student of success principles with a focus on modeling success factors.

25 Comments

  1. The above information is somewhat incomplete. There is far more you need to do to have a “legitimate” LLC than having insurance. You really should also have bylaws, an operating agreement, buy/sell agreement, etc. What is required/a good idea will vary from state to state, and someone forming an LLC should consult with a reputable attorney in his/her state.

    Second, an LLC (at least in my state) does not protect you from your individual acts, and where the only person acting on behalf of the LLC is you, you would be liable for almost anything the LLC would be liable for. In those cases, an LLC will provide almost no protection.

    An umbrella policy CAN be a good (and inexpensive) way to protect you individually.

  2. Good points, Doug. Can I take this one step further? If you have an LLC but have not properly registered it where you are doing business, you may find yourself completely defenseless! For example, an investor attends one of the RE Guru seminars and signs up to have them establish a Nevada or Wyoming LLC, which they use to purchase rental property in California. They fail to register the LLC in California, and get sued by a Tenant for an injury. The LLC cannot even appear in Court to defend itself, and the Tenant obtains a default judgment. Or the LLC wants to file an eviction action against the Tenant for nonpayment of rent. No can do. LLC must register in California. This same concept applies to all LLCs no matter where they are formed or are doing business.

    • Great followup info. I too am just starting and looking at ways to properly protect myself. I did attend one of the guru sessions where they did recommend that you use a state such as Nevada as their courts tend to protect the corporate veil higher than other states. As Jeffery had noted in the example above that since the LLC wasn’t registered in CA also, does this mean you can register the same LLC in multiple states?

      • Yes Tom you can and should register the LLC in any state that you expect you will be doing business in. I’m incorporated in NV and in order to business in my state it costs about $200 to foreign file.

    • Wouldn’t the LLC need to provide a letter of good standing from the Sec of State for the attorney or title company to close the transaction?
      I’ve always needed to do this in any state that I have bought in.
      (These include both financed and cash purchases)

      • Douglas Dowell on

        Shaun, I agree that’s a great procedural thing title companies do to keep things kosher. The real danger for someone is doing a transaction outside of the title company realm. I.e. a lease transaction. IF your LLC is from another state and not domesticated you will be unable to enforce your legal rights. Not cool.

        • I guess since the original comment said “buying” a rental in another state I was assuming title was being transferred and either a title company or attorney would be pushing paper.

  3. I had this conversation with my lawyer and he also confirmed that piercing the corporate veil is commonplace in todays courts. His suggestion was to use an umbrella policy and to be over insured.

    At first this enraged me, why even allow a small business to form a corporate entity if there is no legal protection. But after further conversation with my lawyer he made a great point about how the insurance company will be the ones representing you in court, therefore paying for your legal fees. The savings of legal fees alone will more than cover the extra cost of being over insured.

    • Douglas Dowell on

      I appreciate that Chris,

      A great umbrella policy is worth its weight in gold to me. The aspect of subrogation (stepping into the policy holders shoes) is a core concept in the most use-able of asset protection plans. Its available and cost effective for even the most modest of business ventures.

  4. I appreciate this article. I’m looking to start investing in real estate in the near future and have been trying to gather as much information as I can to make informed decisions.

    With respect to your comment about being poorly capitalized, are there any guidelines for what would be a well capitalized entity or is that state specific?

    In the case of a poorly capitalized entity, does anyone know if it would provide you any protection if you provide occasional funding to your business entity to cover large expenses, but don’t withdraw any funds for the first few years of its existence?

    • Douglas Dowell on

      Thank you for the comment David,

      I would def. recommend speaking to an attorney in your state before acting. It seems to me however, as a general rule if you have umbrella insurance policy you can greatly reduce the exposure to this attack.

      I would recommend reading this article: http://goo.gl/XdWXmc. It will give you a great flavor of that aspect. I think from the reading if your growing a business and it has thin liquidity is a different reason than the thrust of veil piercing base on the article.

      The main point is if you are just draining the corporation to keep it in low cash position is the focus. Very different fact scenario in my opinion. The case law in Texas is probably very different in California however. The jurisdiction your in probably is very important on this topic I would guess.

  5. The good thing about trusts is that you can be pretty anonymous. When someone is looking to sue the owner of the property, they first have to find out who actually owns it. If in doing a search, one finds “123 Elm St. Trust” with a PO box as the mailing address, it will take work for a lawyer to obtain info on who to actually go after. You can own each property in it’s own trust. It’s also easy to change the beneficiary and trustee on revocable trusts. In addition, you can form a property management company in an LLC to manage the properties. I have set myself up this way with liability insurance policies in place for each property, the management LLC, and me personally. I never tell tenants that I own the property, but that I work for the management company, which is true. I don’t know if it’s perfect but it’s what I have come up with. Hope this helps

  6. One of the guru’s says that one of the ways to prevent the problems of a single person llc’s (with ease of piercing the corporate veil), is to use a c corp as a second member (with even a 2% share). Is this a valid strategy?

    • Douglas Dowell on

      Hello Kevin,

      I am not sure I agree with that strategy as a way to stave off a veil piercing attack. Your state law may have a quirk that makes that so??? But I just don’t see the angle.

  7. Some statistical evidence would be very helpfyul – such as how often landlords get sued by tenants and how often the LLC is successful in protecting unrelated assets of the landlord. In a typical situation, equity in the building itself would still be at risk – with or without an LLC.- because it is being used in the business (the LLC) and is most likely property of the LLC. The liability limitation weould only come into play if liability exceeds the limits of the insurance plus equity in the property, and if the owner’s actions aren’t at issue

    • Douglas Dowell on

      That would be pretty interesting Matthew,

      I have yet to see any reliable data on that point myself. I would guess fairly low number overall. The key point if you get caught up in that situation its best to have your ducks in a row so to speak.

  8. There is another issue that comes with the LLC – how to hold your title. If you hold the title in the LLC’s name you can’t obtain a conventional 30 year fixed interest rate loan, so you are back to a commercial ARM. Some people suggest that you can transfer title after you have secured financing banking on the fact that nobody will check as long as you make your payments on time. I wonder if it would make sense to rent the property to the LLC (in a master lease) and the let the LLC sub-lease it to the tenant? Does anyone know?

    • Douglas Dowell on

      Hello Marcus,

      It seems to me that as a practical matter that either approach will likely get the same effect, I do really like the master lease option to create an additional entity layer. The very slight risk of deeding the property outright is risking acceleration of the due on sale clause. It seems that’s a low risk probability.

  9. Doug, your article is extremely informative and helpful. However, you give no examples of the precautions you urge. Also, not to be picky, but you really should proofread for typos and grammatical errors. For example, “they plaintiff” and not the correct “their plaintiff” undermines the veracity of your advice (which, generally, is good).

    Best of luck
    Stephen Scott, Esq.

    • Douglas Dowell on

      Hello Stephen,

      Thanks for the suggestions for improvement. The objective for my post is engagement therefore I make a strategic choice on what goes in and how much detail is included.
      Always a challenge for a math geek to write.
      The profreading needs to improve without question.

  10. Sole proprietorship is the way to go..You can take more deductions that way and if one is concerned about lawsuits then just get liability insurance or a similar insurance to protect you..

    Of course a competent real estate attorney will always know what’s best but 2 investors I know have sole proprietorship and they’ve never had any problems

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