[Editor’s note: The following is meant for informational purposes and is not legal advice. For information pertaining to your specific legal situation, please be sure to consult your attorney.]
Real estate asset protection is a favorite strategy used by rich real estate investors. The rich don’t take the same risks you do; they use the law to their maximum advantage. It’s not sleazy, it’s using the rules available to your maximum advantage. The most underutilized tool is an effective contract. Below, I’ll show you one little used trick to create maximum leverage in a lawsuit—and the most effective way to protect yourself should one ever result.
A highly effective tool that many don’t use is a contract with terms that favor you when a deal goes sideways and litigation could result. We don’t want litigation to actually happen because it is expensive—what we do want is a contract that gives us huge amounts of leverage to get the settlement we want quickly.
To protect yourself from lawsuit—and to protect yourself even in the event you need to sue someone (YES, suing someone does put you at risk)—you will want to use an LLC. The rich use LLCs.
Download Your FREE Tenant Screening Guide!
Hey there! Screening tenants can be a tricky business, and this critical step can be the difference between profits and disaster. To help you with your real estate investing journey, feel free to download BiggerPockets’ complimentary Tenant Screening Guide and get the information you need to find great tenants.
Have the Remedy in the Contract
If the remedy is spelled out in the document, then you don’t have to rely on complicated legal matters for your remedy. If you’re buying real estate and the deal goes bad, do you want the property or do you want money? If you want the property, you need a provision for “specific performance.” Otherwise, what you’re left with is a suit for “damages” and money. The bad part about “damages” is you have to prove how much you have been harmed.
Related: Landlords: The 6 Best Ways to Minimize Your Chances of a Lawsuit
Unless you were getting a killing on the property compared to the comps in the area, how do you show how much money losing the deal cost you? The solution to this problem is known as “liquidated damages.” This is a clause that specifically states the amount of damages in the case of breach of the contract, i.e. the other side backs out.
For example, the contract could say if the seller refuses to execute the sale after the buyer obtains financing for the deal, then the seller is liable for a liquidated damages amount of $40,000. Note that this should be one sided to your favor so that only the buyer has these rights. This gives you leverage over the seller since they know they have much to lose instead of having hope of low damages being determined by the court.
Some people say the seller will balk at this type of clause—and they likely will. But you can counter by asking them, “Do you have any intention in backing out of this deal after I put in thousands of dollars’ worth of man hours and hard cash? No? Well, this clause is to ensure that you won’t and gives me confidence to know you’re serious about moving forward.” At the very least, this opens the door to a negotiation about what amount of liquidated damages are agreeable between you two. If litigation does result, your future attorney will kiss you.
When a Deal Goes Bad, You Should Be Prepared for the Lawsuit
Even if you don’t believe anyone would ever sue you for any reason and you are 100 percent sure, you will still want an LLC for protection. You may not be sued, but you will need to sue someone. When you sue someone else, you put yourself at risk. In the United States, the prevailing party, which may be the other party, can be awarded attorney fees. You would be surprised to find out that the damages could be only $1, but since the other side prevailed, they get $30,000 in attorney fees. If you sue someone, it could come back to bite you.
How Does the LLC Help?
The LLC acts as the plaintiff to the lawsuit instead of you personally. Since the LLC is the plaintiff, if there is an award for attorney fees or other damages, then they can only look to the LLC. The cost to file a new LLC is MUCH cheaper than the cost of paying off a judgment. Also, remember that if a judgment is ever filed against you, then it appears on your credit report, harming your score. Since we are in the borrowing business to leverage our hard dollars with those from the bank, this hurts our bottom line.
What Does This Mean Practically?
You should never buy a property, hire a contractor, or talk to anyone—your operating shell LLC should. The operating shell LLC is an LLC that has no assets and is the face of your business dealings.
You can only sue someone that you interact with, either in contract or communication. So, if you want to insulate yourself from lawsuits, then you have to act through a business entity. How do you do this? Create an LLC that owns little to no assets and acts as a shell. Since that LLC made all of the communications and entered into the contracts, then that is the only entity that they can come after. So when a lawsuit happens, what do we care? Our worst case scenario is that we wind up the LLC (i.e. destroy it) and start a new one. It’s not a sketchy thing to do, it’s using the laws that exist to our advantage.
The elephant in the room usually regards when the LLC isn’t effective and the court says you have “pierced the corporate veil.” I don’t care about piercing the corporate veil. I anticipate that as a possibility when I use an operating shell LLC. Even if the court were to “pierce the veil” of my operating shell LLC, the worst case scenarios is that they can attack me personally. Guess what? I don’t own anything; my separate asset holding LLC does.
Rich people don’t own assets, and their operating shell LLCs don’t own assets, either. Under this type of legal strategy, even if they are able to pull every legal trick, the worst thing that someone can do is harm a credit score. The reality is that nobody spends the cash to hurt you when they know they’re not getting anything in return; lawsuits are a business.
[Editor’s Note: We are republishing this article to help out our newer readers.]
Investors: How do YOU protect your assets?
Leave a comment below, and let’s talk!