Yes, You Absolutely SHOULD Use an LLC to Invest in Real Estate: A Counterargument

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My initial reaction to Scott’s article “5 Reasons I Do NOT Invest in Real Estate Using an LLC” was that his advice is perhaps the worst/silliest advice EVER.

Please don’t do this. The disadvantages FAR outweigh the gains (and can be done through an LLC anyway). Of course, in hindsight I think I was too harsh, and when limited to the 140 knee-jerk characters in my tweet, I didn’t do Scott’s thought process justice.

Brandon Turner at BiggerPockets asked if I’d like to craft a rebuttal, and now, having had the time to reflect, and after speaking with Scott, I think my response is more along the lines of, “I’m jealous of Scott. I wish I had purchased my first rental when I was 24. When he acquires more rentals and becomes the family guy with more assets that he describes in the last paragraph of his post, he’ll surely conduct his business through and LLC.”

Before I dive in, a few disclosures to connect me to some of the things Scott points out in his article. I am a lawyer (real estate). I am, in Scott’s words, close to “50 with three kids to put through college and a few million in assets to lose.” Not sure about the “few millions,” but I do own 8 residential homes. I am not thoughtless (unless, perhaps, you ask my wife on occasion). I might be very wrong. But I’m not selling you anything. And, again, I am jealous of Scott – I wish when I was 24 I had started buying real estate and not waited until I was close to 40.

The upshot to my rebuttal is this: If you’re a young first time investor, then perhaps you can get away without owning your real estate assets in an LLC. If you don’t fit in this category, use an LLC.

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Financing

As you likely know, financing is a major driver when investing in real estate, whether residential or commercial. And in the current environment, as cap rates decrease and prices compress, financing becomes even more important to the equation to successfully invest in real estate. As Scott points out, having the ability to obtain financing as an individual is a major advantage considering that the commercial financing terms are not as friendly. So, by all means, finance personally. I agree with Scott.

… with a twist. At some point your bank will advise you that your debt-to-income ratio exceeds the limit that allows you to finance in your own name, and you’ll have no choice but to obtain commercial financing. But until that tipping point, finance in your own name for the better terms.

Allow me to point out, however, that financing personally makes you personally liable to repay the debt. This means that if you default and the bank forecloses and the bank has a deficiency, the bank can come after you personally for the difference. I have to admit this doesn’t occur very often, but the terms of your home mortgage are recourse, making you personally liable.

If you finance through an entity, only the entity is liable for the deficiency. As a person, you are separate and distinct from the entity and protected from this repayment liability unless you were required to sign as a guarantor (which may be likely). So in that case you’ll be on the hook anyway.

It would seem that Scott’s argument wins the day. Or does it? Many (most?) lenders, including mine, allow you to finance individually while owning the assets through an entity, if the entity is owned/controlled by you. So, until you hit that debt-to-income ratio I discussed above, discuss with your bank if you can finance yourself but own the assets through your entity, thus benefitting from the advantageous rates/down payment, while at the same time enjoying the liability protections of owning through an entity.

Tax Benefits

The very same tax benefits available to individuals are available if you own your homes through an entity. This is so if the entity is a pass-through for federal tax purposes. You can make this happen by being the sole member of the LLC (or sole members if you own as husband and wife). So, if you form your LLC as a pass-through for tax purposes, you can still claim the deductions that Scott details. And you get the liability protection of using an LLC. Scott: 1, Rob: 1. Tie game.

Related: Should You Get an LLC For Your Real Estate Business?

And a fine point on paying capital gains taxes — the avoidance-of-capital-gains-taxes-on-a-sale applies to the gains from the sale of your primary residence only. Not property used solely for investment. So if you don’t live in the house, you can’t exclude the gains from taxes. If the house is a rental, you can’t exclude the gains from taxes. If you live in half of the duplex, like Scott, you should be in good shape.

But this is still the case if he owned the house in a pass-through entity or individually.

Mixing Business With Personal

Corporate formalities can be a pain in the rear, I admit. As Scott mentions, using separate emails, separate accounting, etc. can be tricky sometimes. And if you own the house in your own name, there is an argument to be made that you don’t need to worry about the separate-ness. So, point to Scott. But if you follow a few basic rules about separation of the entity from your personal life, piercing the corporate veil would be difficult for anyone trying to get to your personal assets.

But I can’t say there is much of an advantage in the spirit of being able to rent to whomever you want if you own personally – unless you want to discriminate. While is it certainly true that federal discrimination laws may not apply to individually owned homes, as Scott mentions, discriminating against someone because of their nationality, handicap, color, religion, etc. is immoral and unethical.

But any valid reason you might want to refuse to rent to someone when you own as a business is allowed. Criminal background, bad credit, poor references, insufficient income, prior lease defaults/evictions, unemployment, etc. These all qualify as valid non-discriminatory reasons not to lease to a potential tenant. You don’t need to own the rental personally to rely on one of these reasons.

Limited Liability and Umbrella Insurance

The benefit to owning properties through an entity rather than individually is limited liability protection. That is, only the entity is subject to any liabilities, lawsuits, judgments, etc., not the owners. The owner’s liability is limited to the amount of equity in the entity. This means that any additional liability above and beyond that amount is the responsibility of an entity with no additional assets.

Let me give you an example (ignoring liability insurance for now). Let’s say you have owned a house for a few years. You have benefitted from amortization and a rising housing market. The house is now worth $200,000, and the outstanding mortgage is $140,000. The amount of your equity is $60,000. You fail to fix a faulty rafter that should have been repaired. It falls. It hits someone on the head. They sue for damages. They get a judgment for $600,000.

This is a simplification, but if you own the house through an entity, the entity is on the hook for the judgment. Your $60,000 equity is also lost. That’s it. The entity is on the hook for the remaining $540,000. The entity has no other assets, so the injured party is stuck with a judgment against an entity with no assets. You walk away. If you had owned the house personally, you owe the injured party the full $600,000. While certain of your assets are creditor protected by law, you now personally owe someone $600,000.

And it’s not quite as simple as Scott points out as starting over. That judgment sticks with you for years and years (depending on jurisdictions). Of course, liability insurance will cover a good chunk of this, so now let’s talk insurance. Let’s say your liability coverage is $250,000. Insurance should cover that amount of the judgment, which means you personally are left holding the bag for $350,000 — a judgment that sticks with you for years and years.

For a couple hundred dollars a year, you can increase your liability protection to $1 million by obtaining an umbrella policy, as Scott mentions – that is one of the smartest insurance products you can obtain. I have a $2 million umbrella policy because, as Scott mentions, I’m older with more assets and want more protection. My umbrella premium is around $330 per year. Money well spent. In the example above, you don’t come out of pocket anything because the remaining claim is under the amount of your umbrella policy.

As Scott points out, “a $1M+ mistake on [his]little rental would be an extraordinarily unlikely event.” I agree. But what if you own your own residence (possible slip and fall on your sidewalk), own 8 rentals (a faulty rafter injures someone), perhaps you run your own business (and injure someone), own a car (which contains the possibility of hitting someone, the damages for which exceed your auto liability coverage), etc.? Is it possible that with all this going on, the potential damages could exceed the liability coverage amount and the umbrella limit? It sure is.

But if you own all your rentals through an entity, the maximum amount of your out-of-pocket loss is the equity you have in the entity – after exhausting both types of liability coverages. You don’t have to worry about any slip and fall, and rotting wood, any work accident, and auto accident, etc.

Do not put your personal assets at risk. Simply use an entity to own and operate your properties.

Note that while a separate entity for each property you owns further isolates liability (in that the potential loss is only the amount of equity in each individual property), it can be expensive. Some states allow entities to create “series” (sort of like different shares) that can further isolate each property from all others. If so, form just one entity, but create a separate series for each property separating the debts and liabilities from one property from the others.

Related: #AskBP 013: Should I Have Several LLCS For My Real Estate Business?

Negotiate With a Higher Authority

No, this isn’t an article about religion. The higher authority to whom I’m referring is anyone other than yourself. What I mean is that you lose negotiating leverage any time the counterparty knows you can make the final decision. So don’t let them know that you make all the decisions. You are much better off if your tenants think you can not make any decisions. But oftentimes when someone owns his/her rental personally, pride and hubris lead them to tell the tenant that they are the owner. And they make all the decisions. They don’t need to listen to someone else.

But owners are much better off if their tenants think that they just manage the property for the “owner group.” That way they can’t be cornered into making decisions. They can work with the tenants (or pretend to be on their side) and always defer to a higher authority that makes decisions regarding the property. They can listen, then take the time they need to consider other options. The tenants feel that they are on their side.

Then, if they want, they can return with an answer (after having had time to think about the issue) and say, “Hey, I discussed with the owners, but they aren’t willing to spend the money to fix _____ right now. I tried to make your case for you. But they offered the following alternative that I think will work…” In this sense, you can still remain an anonymous owner.

Upshot

Most of the advantages of owning property personally can still be enjoyed by owning through a limited liability company of which you are the sole member (a so-called “single member LLC”), with the very important added protection of limited liability.

Oh, and as always, consult your accountant, tax professional and attorney.

Investors: You’ve heard both sides. What do YOU think? Do you believe an LLC is the wisest way to invest in real estate?

Leave your opinions below!

About Author

Rob PIvnick

Rob Pivnick is a real estate investor, entrepreneur, attorney and financial literacy advocate. Rob has both a law degree and an M.B.A. from SMU in Dallas, TX. Professionally, Rob is general counsel for a private real estate investment company and has authored the book What All Kids (and adults, too) Should Know About Saving & Investing.

31 Comments

  1. sandy salazar

    Ok so I wasn’t the only one who cringed when I read Scott’s article. Then again I can understand his point of view from where he’s at in his life. Young, unmarried and without children (not that I’m discriminating). I did purchase my first property at 27 and had 7 doors before I hit 30, however my mentality regarding the financial security of my family when I first purchase my real estate as a newly wed is completely different than after having multiple units with two little kids futures to think about. All it takes is one sue happy tenant or a guest of a tenant to tear down my “mini” real estate empire that I’m trying to build. One law suit and it will hinder my abilities to qualify for future finance deals, to garnish our w2 wages that we use to finance our real estate deals, to force me to liquidate all my positive cash flow properties to pay for the damages incurred (not including my own home if my rental properties did not fulfill the financial judgement against me). Multiple that risk by 7 units (and more, I’m not planning on stopping my real estate purchases) then I might as well be paying my renters to live free in my properties in exchange for a signed agreement releasing me from all liabilities if harm and injuries incurred for my tenant or any of their guests at one of my properties.

  2. Minh Le

    Rob,

    I agree it makes sense to buy and finance properties under your own name until you get above 10 mortgages and have to go with commercial financing. Most investors never got more than 10 properties unfortunately. I hope they are savvy enough to understand the benefits of owning properties under a LLC once they get there.

    I guess both you and Scott are right. It just depends on which stage you are at your real estate investment career. One size doesn’t fit all in this case.

  3. cheryl c.

    Hello Rob,

    I still don’t see your argument. I’ve got a 5MIL umbrella and 20 rentals (plus cars, boats, personal residences, etc.). Why do I need an umbrella? Where is my excess liability? What is my exposure?

    • Zach Barnes

      Say there is a fire at one of your rentals, people die, or are injured badly enough to need lifelong medical care, and youre so unlucky one of them was a neurosurgeon who makes 1 million a year that will never practice again.

      Yes, extreme, but that situation would put everything you own in jeopardy. I dont get the difficulty here, its simple and provides you with protections and benefits.

  4. Jeffrey Hare

    As a real estate attorney who is often asked this question, I applaud Rob’s fair and thoughtful rebuttal. I would like to add two points of emphasis. First, there is no “one-approach-fits-all-risks” solution. Investments – and life – evolve through time, and as a result, you will need to evaluate and adjust your strategy accordingly. What worked for Scott when he was 24 will probably not work for him when he turns 40. As Rob and the rest of us say over and over again, consult with your legal, tax and estate planning professionals! Second, there are no silver bullets. Quiz: To be successful, do you need (a) competent property management, (b) adequate and suitable insurance policies, (c) proper entity selection and maintenance, or (d) sound ethical judgment. Answer: All of the above.

  5. Bliss J. E. Mitton

    I agree with Rob.

    I would like to mention that the LLC does not protect you from personal actions. If you punch your tenant you are still personally liable.

    If you do not have a LLC when starting out you can consider a land trust. Once you have the base paperwork done the cost of each new trust (for each new property) is only the cost of recording ($15 in my area). It keeps your name off the county records and provides some liability shielding.

  6. Darrel Donatto

    But for those of us living and operating in Florida, there is a bit of a twist. Single member LLCs do not offer any additional liability protection or limitations. Thus, if you want added liability protection, you must incorporate as a multi member LLC and this changes you tax filing structure, your insurance profile, and your access to lending. For smaller investors such as myself with 7 properties, I find it better to just buy more insurance.

    • Logan A.

      I believe the term “disregarded entity” is strictly a tax term, which simply means that the entity is ignored for tax purposes, i.e., its activities are treated as the activities of its owner for tax purposes.

  7. Logan A.

    I spoke with a real estate attorney who told me that an LLC with less than four properteis would provide a very thin, easily pierceable corporate veil. Although this is not codified anywhere, and this number is based only on this attorney’s experience in the jurisdictions in which he practices, his opinion was that once an investor acquires four or more properties, a single-member LLC would potentially make sense because at that point the LLC is “vested” (again, his language and not a codified term), which means that it now has a decent shot at being respected as an entity separate from its owner for liability purposes. It is now standing on its own two feet with multiple properties and multiple incomes. But before that point? Not worth the out-of-pocket cash, which in California consists of a $70 filing fee with the Secretary of State plus the $800 franchise tax plus an additional fee based on gross receipts. Thoughts?

    TL;DR: Real estate attorney told me that an LLC will likely not provide much protection if less than four assets are in it because it will likely not be respected as an entity separate from its sole owner. Can anyone speak to this?

    • Jeffrey Hare

      The point has been made before on Bigger Pockets (Brandon Turner and others) that one should do a cost-benefit analysis when deciding whether to set up an entity. But that analysis needs to consider ALL of the risks for which you are seeking limited liability protection. The number of properties owned is largely irrelevant as to how much an entity can provide protection of your personal assets. Using Rob’s example above, a $600,000 claim based on tenant’s injury (assuming no personal negligence on the part of the property owner) will be limited to the $60,000 in equity held by the LLC, and cannot reach your personal assets. Even in California, under that scenario, the $800 invested in getting the LLC would seem to be a good investment. But if your analysis is only focused on net income from a single investment property, it may not seem prudent to pay for a LLC. YMMV. Be sure to consider ALL risk factors.

  8. Tim Shin

    @Rob Pivnick thank you and Brandon Turner for this article. I mean seriously, when Scott wrote that article I pictured all of the poor folks who are going to listen to him and get exposed and make a mistake. I don’t see any benefits afforded to you from not owning your rentals in a corporation that you couldn’t get inside a corporation or LLC. It doesn’t cost much to get one set up properly! Scott could be come married or engaged this year and if something went wrong outside of his umbrella policy that would be horrible.

  9. Rob Beland

    You don’t mention tort lawsuits in your post and as an attorney I would think that would be a huge consideration for a new investor. If you use your example of failing to fix a faulty rafter that falls on somebody and there is a lawsuit then as the owner of the property you will likely be found negligent. No layer of LLCs and management companies will protect you in a case of negligence correct? So you have the LLC set up but since you did not repair the faulty rafter then your LLC is not going to protect you and the plantiff is going to go after your personal assets anyways. Correct or no?

    • Jeffrey Hare

      For the nonlawyers in the room, a “tort” is another way of describing a legal action for negligence. Rob Pivnick’s example was based on tort liability, in which a party can be held liable for negligence if certain elements can be proven, such as whether the owner failed to fulfill or meet a specific duty he or she owed to someone and as a result that person was injured. Although the injured party will almost always allege that the owner was negligent (hence alleging a “tort” as opposed to an action based on breach of contract), the plaintiff must still prove that owner was personally liable. There are numerous other possible reasons a party could be injured in this setting that are not necessarily the result of the owner’s negligence. Ironically, though, the other causes – unlike negligence – may not be covered by the owner’s primary insurance policy.

      • cheryl c.

        I may be pretty thick, but what other “causes” may not be covered under the umbrella? I am having trouble coming up with a cause of action not based on Tort. I can see a concurrent Breach of Contract action; possibly based on a failure to maintain under the lease contract, etc. Is a breach not covered by the ins. policy?

        I imagine the insurance company will come in to defend any action and that a plaintiff attorney with knowledge of the coverage and limited recourse against the LLC would craft their suit to come under the policy. Where is my thinking going astray?

        I’ve been trying to get a definitive answer here on exposure absent an LLC. I suppose I should read my policy.

        Can anyone give an example of a successful lawsuit against a LL where the umbrella didn’t cover?

  10. Steve Phelan

    TL;DR: umbrella insurance will protect you once but then the cost of insurance will skyrocket (if you can get it at all)

    What the attorneys don’t tell you is that when a lawsuit is filed they will go after all parties involved. This means they will sue the LLC, you personally, the property manager, any holding company etc. Placing your property in a trust is an attempt to hide the ownership trail but a court can order you to reveal the owner/beneficiary.

    Generally, they won’t be able to pierce the corporate veil and your insurance will cover the cost. But here’s the rub. Your insurance premiums will go through the roof after a lawsuit. In many cases, the insurer will decline coverage and you will be left with “special” insurance carriers if any at all. My wife’s business was forced to close because you couldn’t get cost-effective insurance after one lawsuit (even with a signed liability waiver and the case being settled out of court with no admission of wrong doing).

    Some clever lawyers we spoke to suggested we should have moved the assets every year to a new LLC with a clean insurance record (which they claimed roller rinks do regularly as they average one lawsuit a year). However, most insurance companies will do a search of the principals of the LLCs, make the connection, and then deny coverage. Note, if all of your properties are in one LLC then theoretically all of your properties are at risk over one lawsuit.

    All in all, we live in a society where people think it is just and right to be (excessively) compensated for anything bad that happens to them (whether it was their fault or not, and whether they accepted/mitigated the risk or not). This expectation is built into insurance premiums but insurance companies also manage risk by assuming that those that have an “event” are naturally more risk prone. I’d say that most people are blissfully unaware that insurance is often a one shot deal.

    That being said, I’d be interested in hearing from people with multiple properties who have been sued about how much their insurance premiums actually increased.

    For more on frivolous lawsuits, see:

    See: http://www.instituteforlegalreform.com/issues/lawsuit-abuse-impact

  11. Jeffrey Hare

    The tragic story about the collapsed balcony in Berkeley broke this morning (see link below) as I was writing a response about tort liability and the fact that the issue of causation is not always crystal clear. The owner of the building in this scenario is reportedly a Limited Partnership, which has some similar liability protection aspects of a LLC, in that the limited partners theoretically have some protection for personal liability. This balcony collapse, which so far has resulted in a reported 6 deaths and 7 serious injuries, will undoubtedly end up with a total damage claim exceeding whatever insurance policy(ies) were in place, as well as any umbrella policy(ies) in effect. But the issue of causation will be the basis for extensive analysis by experts for months to come, and will provide a textbook example of why most real estate attorneys recommend that owners of investment property should get competent property management, adequate and suitable insurance coverage, a properly maintained entity, and apply sound ethical practices. The extent of damages and loss of life in this tragedy will unfortunately serve as a grim but real reminder for everyone. http://www.sfgate.com/bayarea/article/Five-dead-8-hurt-in-Berkeley-balcony-collapse-6329902.php

  12. Rob PIvnick

    The last few comments really highlight the issue. Liability insurance only covers what the policy states, and then only to the limit of the policy. So in the faulty-rafter-example (which is a tort claim), the insurance will only cover to a certain amount (the amount of the policy). And insurance companies look NOT to pay claims. So if the landlord was reckless or intentional in not repairing, rather than just negligence (which is surely covered), there is a possibility that the liability coverage will not cover all or some of the claim (if at all).

    This, of course, is when the umbrella policy comes into play to address the deficiency. Again, there may be cases when the insurance provider finds a reason not to pay, so some or all of the deficiency will remain outstanding.

    At some point, its possible/likely that the remaining amount is at issue. And it is at this point that If the asset is owned personally, all non-creditor-exempt property is subject to any potential remaining judgment. That means house (in some states), auto, retirement (in some states), other savings, etc. If the asset is owned in an entity, none of this is available to satisfy the judgment.

    How about piercing the corporate veil, many of you have asked. . . . There is a presumption that the entity is a separate and distinct entity from the owner. So the burden is on the plaintiff, not the landlord. But with proper separation, the veil shouldn’t be pierced . . . that is, have separate accounts, don’t pay your anniversary dinner bill from the account used for the asset, follow standard simple corporate formalities (resolutions, signing as the proper agent/officer of the entity), be adequately capitalized, etc.

    It is NOT an easy burden to prove, and the plaintiff seeking to pierce the veil must show that, essentially, there is no distinction between the owner and the entity. Even in [commercial] cases in which one would think that the owner operated the entity without attention to the corporate formalities and the veil should be pierced, courts are reluctant to do so absent fraud or a very, very clear showing of flaunting the corporate form.

    Hope this helped.

  13. Matt Thielke

    What are the steps you would need to take if you want to house hack, like Scott, and then a year or more later move out of that property and create an LLC for that property? Is that a difficult process to do and would that create the corporate veil for liability protection? Thanks in advance!

    • Scott Trench

      Matt – I plan to do this over the next few years. My goal is to build up to 20% equity in the property by doing three things:

      1) Working on the property to increase it’s value (repairs, cosmetics, etc)
      2) Working in the neighborhood to keep it clean and desirable
      3) Paying down my loan with proceeds from rent savings and the small positive cash flow that my tenants provide.

      Once at 20% equity, I plan to refinance and move the property to a pass-through entity like Rob describes (If you time it right, forming an LLC costs just $1 in Colorado in certain months). I’ll then buy a second house-hack property. Depending on the cost-benefit analysis on that second property I may purchase the property under my own name, or may purchase it with an LLC.

      • Jeffrey Hare

        Just a warning in anticipation that everyone will want to know how to get a LLC in Colorado for $1 — if you are a California resident, and you own or manage a LLC in any other state other than California, you most likely will be required to file a Form 568 with the California Franchise Tax Board, and pay the annual $800 tax.

  14. Kyle Doney

    With the example, a $600,000 claim based on tenant’s injury (assuming no personal negligence on the part of the property owner) will be limited to the $60,000 in equity held by the LLC, and cannot reach your personal assets. If the LLC had 600k in equity AND an umbrella policy, would they first take the equity to cover the lawsuit or would the umbrella policy cover the 600k first and the LLC would be safe from losing the assets?

    • Peter Belz

      The umbrella policy would pay first in your example, Kyle – up to its dollar limitation, of course. That is the purpose of the umbrella policy, to protect your (or the LLC’s) assets in the event of a claim. If it worked in reverse, there would be no point to maintaining an umbrella insurance policy.

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