Why an LLC for Your Rental Property May Not Protect You From Lawsuits
Published Oct 18, 2019
— Last updated Oct 22, 2019
The cliche situation that rental property owners hear about is "what if your tenant slips and falls and they sue you". Even people who have never been a landlord have often heard of that hypothetical scenario. Just thinking about that situation has probably prevented some people from getting involved in owning rental properties at all.
But a lot of real estate investors also think they know what the solution is to eliminate that risk. They think, no problem I'll just put my rentals in an LLC and they believe that it will protect their personal assets if there is a lawsuit involving their rental. They've probably heard of LLCs, and they may know that it stands for "limited liability company". And it sounds like it does exactly what they want, to limit their liability. Except, it might not really do that at all, particularly if they're concerned about potential lawsuits.
An LLC Won't Protect the Value of Your Real Estate Property
First, this may seem obvious, but it's worth mentioning this since a lot of investors get hung up on the idea that an LLC means they're completely protected. So it's worth pointing out that if someone has a claim against your LLC, they can take the assets held by the LLC, which means that can take the real estate, which may be of substantial value.
But that's not all, they can likely also go after your personal assets as well in many cases ...
An LLC Also May Not Protect Your Assets From a Liability Lawsuit
An LLC in many cases may not do the one thing investors thought it would do for them — offering protection of their personal assets from lawsuits. People often assume that if their rental property is in an LLC, they don't have to worry about someone filing a lawsuit and taking their own personal assets. But that may not be the case.
Let's look at an example of why that is. Although it rarely actually happens, if someone did slip and fall at your rental property, the assumption is that they would have to sue your LLC if the property is held in an LLC. And therefore at worst they could bankrupt your LLC and take the assets (the properties in it). But what prevents them from just suing you directly? It turns out, not much.
If they can reasonably make a case that you were personally negligent in a way that caused their harm, there's no reason they can't sue you directly. All they have to do is be able to have a reasonable claim that you should have repaired that walkway, or you should have made the stairs less slippery, or whatever the specific issue may be. Making that claim is especially easy to do if you're managing the property yourself. Then it's clear that you are the person who is ultimately responsible for ensuring safe conditions at the property, so they can just sue you directly. Is this situation, your personal assets are not protected by the LLC.
But that's not all. Even if there is no reasonable way for them to claim that you're personally responsible for their harm, even then the LLC still isn't the ironclad wall of protection people believe it is. Actually, that's the term that is used when courts put aside the liability protection of an LLC, it's called "piercing the corporate veil". The factors that will allow a plaintiff to go after your personal assets vary from state to state. But in general, they may be able to do so if they can prove that the LLC is not really a separate entity apart from you as the property owner.
And an LLC Will Make Things More Complicated
Even though an LLC doesn't offer much protection, it may offer some protection in some scenarios, so does it make sense to just go ahead and put your rental properties in an LLC anyway? Maybe, but keep in mind there are downsides to having real estate in an LLC rather than owning it in your own name.
The biggest complication is when it comes to mortgages. Most mortgages won't lend money to a property that is held in an LLC. That doesn't mean you can't get a mortgage. There are lenders who specialize in these types of mortgages. But you'll pay a significantly higher rate in most cases.
The reality is what most real estate investors do when they want to put a property in an LLC is they'll get the mortgage first while the property is still in their own name, and then later move the property into an LLC without informing the mortgage company. It's true that in most cases, the mortgage company won't notice that the ownership of the property has changed. But if they do, you may find yourself in a bad situation. Moving a property into an LLC will likely trigger the "due on sale clause" of the mortgage, which means if the lender discovers the situation, they may choose to demand that you repay the loan in full immediately or face foreclosure. If you find yourself in that situation, you may be able to remedy it by changing the property back to your own name, or by refinancing with a different lender that allows LLC property ownership. But it's not a situation that you want to end up in. But you may want to seek more advice on the specifics in your state and situation, since the specific conditions that will trigger the due on sale clause may vary depending on your mortgage and your state.
Aside from the mortgage, you may also find the property insurance rates are higher for properties that are held in an LLC. And having an LLC will also add a significant layer of complications to your finances and taxes. You'll need to keep the finances for the LLC strictly separate from your personal accounts, and you'll need to file additional forms when filing your taxes. The one bit of good news is a sole-owner LLC will not affect your actual taxes paid since the tax calculations "pass-through" to your personal taxes, so the resulting tax is the same whether you have an LLC or not.
But There Is a Way to Get Real Lawsuit Protection
So what are you supposed to do to protect your personal assets from lawsuits? If you're concerned about the risk of lawsuits (and it's reasonable to have that concern), the way to get protection from that is with umbrella insurance. Umbrella insurance refers to insurance that protects you above and beyond the insurance that you may already have, such as auto and property insurance. Umbrella insurance is there to protect your assets in the case of a lawsuit.
Umbrella insurance typically offers coverage that starts with amounts in range of $1 million or $2 million. When choosing your coverage amount, keep in mind that it's not unreasonable to get more coverage than the value of your assets. The reason is it doesn't cover your assets up to that amount, instead it covers lawsuit awards up to that amount.
But umbrella insurance is what you want if you're interested in a way to protect personal assets from the risk of a lawsuit. And by the way in case you're wondering, I'm in no way connected to any insurance company and we don't offer umbrella insurance. This is unbiased advice based on my understanding of the best available way to protect yourself from lawsuits.
So When Would Having a Rental Property in an LLC Actually Help You?
Even if an LLC doesn't protect you from personal liability lawsuits, it does offer you certain kinds of protection. Primarily, it may protect your personal assets outside of the LLC if there are debts that are only in the name of the LLC, and those debts end up being larger than the value of the property. So if the business operations that you're conducting within the LLC go badly and it ends up bankrupt, your personal assets may be protected if they're outside of the LLC.
But it's difficult to come up with a scenario where that would be the case with a typical rental property. One scenario may be if you purchase a house with cash, and then hire a contractor who completes work on the property, but then the house burns to the ground and you hadn't bought property insurance for it and you owed the contractor more than the land value of the house. In that situation, if it's in an LLC and the contractor's agreement was with the LLC only, he may not be able to go after your personal assets and he may be limited to the assets of the LLC.
Be aware that in most cases, the debt protection of the LLC doesn't include your mortgage because you most likely had to sign a personal guarantee to pay the mortgage when you signed for your mortgage. So the debt obligations of your property's mortgage usually extend to you personally. So your LLC usually won't protect you from your mortgage debt, even if something goes terribly wrong with your property held in an LLC.
So in other words, it seems unlikely that a typical residential rental property owner could end up in a situation where an LLC would actually protect their personal assets. But as always, we advise that you seek advice from an actual lawyer. But when you do, it's worth asking them whether an LLC will actually protect your personal assets from the kinds of risks that you're concerned about.
Disclaimer: I'm not a lawyer. Please use this article as only a starting point to seek legal advice for your particular situation.