As both a Queens real estate lawyer and an estate planning attorney, I am asked by clients with real estate what they should do to protect their assets. They want to shelter their other investments and personal assets from potential creditors of their investment properties. Lawsuits based on slip and falls, environmental contamination, contract disputes, and landlord tenant issues are all potential perils for the real estate investor. Investors usually purchase insurance on their properties, whether they bought through 1030 exchange options or otherwise, but feel that they need more peace of mind. After all, a claim by a severely injured party could exceed their insurance coverage, or their insurer may not cover the claim because of some quirk in the policy. Before discussing more exotic structures like foreign or domestic asset protection trusts (DAPTs), I ask how their property is owned. Many times, the investor unwittingly owns real property in his personal name which, as will be discussed in this article, opens up the individual’s other assets to avoidable claims. The first step to reaching their goal of asset protection is the creation of a Limited Liability Company (LLC) to act as the legal owner of the investment property. If structured and managed properly, this legal entity can provide excellent asset protection through the form of limited liability, while providing important tax advantages.
While sole proprietorships (owning assets in your name) are the most common and simplest form of property ownership, they provide no asset protection for owners. When a person who owns property in his personal name gets sued, all of his assets, even those unrelated to the property, can be used to satisfy a judgment. An example can help illustrate this: Let’s consider Joe, who is single and owns two houses; one in which he lives and one that he rents out. His personal home is worth $300,000 with no mortgage. The rental home is worth $250,000 but has a mortgage of $225,000. Joe signs a deal with Mark, a contractor, to perform major renovation work on his rental home for $50,000, which is not performed to Joe’s satisfaction. Joe does not pay Mark the money because he claims Mark violated the contract. Mark sues Joe for $50,000 and wins. Not only is Mark able to collect against the $25,000 of equity from the rental home, but he is also able to collect the balance against Joe’s personal residence or any of Joe’s other personal or business assets. Had Joe held his rental home in an LLC, Mark would only be able to collect against the value of the property held in the LLC, and not of any other assets outside of it.
A similar mistake investors make is owning multiple investment properties in one LLC. When an LLC is sued, all of that entity’s assets become available to creditors. However, by placing each property in separate LLCs, an investor can protect his other properties from being subject to the judgment related to only one of the properties. This way, if Joe owns two rental houses in separate LLCs and one property is subject to a judgment for an amount greater than his insurance policy and home equity can satisfy, his creditor can’t collect from the other LLC. While there are additional fees to set up and manage two LLCs, they are well worth the protection that they provide.
From a tax perspective, an LLC is a “pass-through” entity, which means that income is passed to its owners, also known as members, and reported on the owners’ individual tax returns. This feature of LLCs avoids double taxation and is similar to that of an S Corporation. LLCs with multiple members are taxed as partnerships and the members have to file a Schedule K-1. Single member LLCs are taxed as sole proprietorships and members report the income on their personal 1040.
The benefits for real estate investors is tremendous; if the proper legal distinctions are observed, a creditor can not enforce a judgment against the investor individually or against any other properties he may own. Consequently, properly safeguarding your LLC is critical and will be discussed in a subsequent article. As with all complex legal issues involving real estate and business law, a competent real estate attorney should be consulted.
Contact our law offices at 347-766-2685 to discuss your individual situation with an estate planning/real estate attorney.