During the early years of my real estate investing I ran my business as a sole proprietor because I was confused about asset protection. All the books and expensive courses only added to the confusion, and the subject of asset protection only became more frustrating for me.
Luckily, I survived with only minimal damage, but there comes a point when it is time to assess the best legal structure to use for real estate investing. This becomes increasingly important as your net worth grows.
Consider this scenario. You are sued for an accidental injury that occurred on one of your properties where you held title in your name personally. You are sued for $2,000,000.Your insurance only covers $1,000,000. That's a very bad day.
The biggest mistake you can make in real estate is to hold title on your property in your own personal name. Title to property is public record. Anyone can look up what you own, determine its market value, and deduct what you owe to determine what they can attempt to sue you for. It's like painting a bulls-eye on your back for prying eyes such as attorneys, creditors and even your tenants.
So what entity provides you the best asset protection? How do you limit your liability exposure?
Now, if you ask 10 experts about asset protection, you are likely to get 10 different opinions. With that in mind, I'll share my opinion and experience. Remember, free advice is only worth what you pay for it.
If you are a beginning investor, it's probably best to not worry about asset protection until you actually have some assets to protect. Why spend your time and money setting up a business entity and creating tax reporting requirements unless you need to? That's like buying full coverage auto insurance on a beat up car that you don't own. What's the point?
Once you have some investment property to protect, then it's time to set up your business structure.
Your first line of defense is liability insurance. You should carry an insurance policy on each of your properties covering all the normal hazards plus liability insurance for as much as your insurance provider will allow. This will vary but may be capped at $1,000,000 to $2,000,000 per property.
In addition to your individual insurance policies, you will want to purchase additional liability insurance in the form of an umbrella policy that covers all your properties and covers you for any shortfall in the individual policies. This is not expensive and is well worth the cost.
Here are the various options when it comes to asset protection vehicles:
Land Trusts: A land trust is basically a living trust used to hold title on real estate so the beneficiaries of the trust cannot be easily discovered. It is a very good tool for anonymity. However a land trusts is not considered to be a separate taxable entity and there are no tax benefits to holding title in it.
Corporations: A corporation can be an effective vehicle to hold your real estate assets. Additionally, corporations have some great tax benefits that may not be available using a limited liability company. For example, the first $50,000 of net profit is only taxed at a 15% tax rate with corporations versus paying taxes at your personal income tax rate using a flow-through LLC. Additionally, you can use your corporation to pay for a large number of allowable expenses using pre-tax dollars.
Depending on your tax situation you may be better off with a C Corporation rather than an S Corporation. A corporation is a C Corporation by default and files a separate tax return whereas an S corporation is specially set up so that it splits its profits among its shareholders. The shareholders then report their income on their own personal tax returns. In some cases it's better to start out as an S Corporation and later change to a C Corporation when the tax advantages become evident. Consult your tax advisor on this.
LLC: A limited liability company (LLC) allows its members (shareholders) to participate in the running of the company without sharing in its liability. Like an S Corporation, the profits and losses flow through to the owners. However, buying and selling multiple properties within an LLC may subject its members to “dealer status”, which would force you to pay taxes on any gains at ordinary income tax rates as opposed to capital gains rates.
Keep in mind that many states do not provide you with anonymity because the officers, directors and/or members of the entity are a matter of public record and are freely searchable on the internet. If anonymity is important to you, consider states like Delaware and Wyoming that offer complete privacy.
The bottom line is you need to cover your assets (“CYA”). Protect yourself with adequate insurance coverage and an entity that provides you liability protection and anonymity.