Best Practices for Protecting Rental Properties

Real estate investors are exposed to greater risks today than in recent times.  We seem to live in a culture where people blame others for their dissatisfaction or misfortune with plenty of hungry attorneys willing to take their case.

If everything you own is in your personal name, you have absolutely zero asset protection.  Which means your business, home and personal assets are all in one bucket and available to creditors.   General partnerships are even worse, because you could be personally liable for the decisions of the other partners as well. 

Segregate risk by creating separate buckets.  To manage risk effectively, your assets and activities should be segregated into separate buckets.  The number of buckets needed will depend on the type of activities, the risk involved and the amount of assets you own.  For example, if you operate a business AND own investment real estate, the two activities should be held in two separate limited liability buckets (perhaps an LLC for real estate and an S corporation for business).   

Hold rentals and investment real estate in LLCs.  The primary purpose of LLCs is to provide their owners (called members) with asset protection.  Some of these protections include, shielding their members from personal liability coming from debts of the LLCs; protecting the homes and personal assets of members from LLC liabilities and protecting LLCs from personal legal issues connected to their members. 

Rentals and real estate investments receive favorable tax treatment under the passive activity provisions of the Tax Code and are especially suited for LLCs, since profits of passive activities aren’t subject to employment taxes.  However, passive real estate should not be held in corporations or LLCs taxed as corporations due to the additional tax consequences.   

Avoid holding too many properties in one LLC. You should restrict how many properties each of your LLCs owns, as anything owned by that LLC is vulnerable if the LLC is sued.  As more real estate is acquired, more buckets (LLCs) may be necessary to effectively manage your risks and provide maximum protection, which helps protect the assets in one bucket from liability coming from another. 

Establish LLCs legal standing. Many small LLCs in California have no legal standing, because they were formed without operating agreements.  Which may cause LLCs to be stripped of their legal rights, their contracts deemed invalid and may prevent LLCs from defending themselves in court or in bringing suit for damages against another. 

Establish your LLC’s rules of operation in its operating agreement. Operating agreements establish an LLC’s rules of operation and governance, such as how conflicts are resolved; how owners are added or removed; a pre-determined formula for valuing an owner’s interest and other important issues.  Operating agreements have legal binding authority in settling issues and may eliminate the need to go to court should a dispute occur, thereby saving you and your LLC thousands in legal fees.

Maintain the LLC veil of protection.  Even LLCs that were properly formed could end up losing their asset protection quality if on-going compliance is not maintained.  LLCs must be respected as separate from their members.  Certain decisions made by their managers must be recorded in their minutes; annual filings must be done and many more formalities must be maintained.

Title ownership properly.  When real estate is held in LLCs, the properties must be properly titled in the names of the LLCs to maximize segregation.  If the property is supposed to be owned by the LLC, then it should be titled that way.  Any assets not titled properly, may not be protected.         

Develop good practices in managing rentals.  Rental properties have their own set of good business practices that must be followed in order to protect the properties and to successfully manage your risk.  Good practices help insulate your LLC from both personal liability and legal issues coming from your rentals.  Good practices include complying with the tenant-landlord laws and not committing any alter ego blunders.

Contracts must be in names of the LLCs. All contacts and arrangements pertaining to the assets of LLCs, it obligations or activities, must be in the names of the LLCs and signed by managers representing the LLCs, such as rent/lease agreements, hiring contractors, arrangements for the personal use of LLC-owned vehicles, etc.

Insure your real estate.  Just because you operate through an LLC legal structure doesn’t mean you can go without insurance.  The law requires that entities act responsibly by carrying the proper type and amount of insurance.  In fact, not having adequate insurance is one of the surest ways to have your LLC veil pierced.

Avoid alter ego issues.  Alter ego means that your LLC appears to be an alternate version of you; that the law cannot distinguish a difference between you and your entity.  If you commit alter ego blunders, the separate bucket of protection may be disregarded by the court.  (See our article on alter ego). 

Don’t do stupid things.  One of the easiest ways for the law to pierce your LLC’s walls of protection is for you to act negligently or fraudulently.  Your insurance policies don’t typically cover for stupid acts either.

Categories: Sacramento Real Estate Tax Planning.