Rental Real Estate - What are the risks?
For people who own rental real estate, you need to ask yourselves if you want to put your house and savings at risk should someone get hurt on your property. That is a risk you are taking if you own rental real estate in your own name and not through some kind of limited liability entity.
Owning rental real estate is a business venture - you treat it on your taxes as such and you should consider treating it as such when it comes to the form of ownership. I recommend that my clients own all rental real estate in the name of an LLC, and if more than one person owns the property, an agreement be drawn up between the parties addressing their rights and responsibilities.
What are the risks to not acting to shield yourself from liability with rental real estate? One is personal financial liability for activities that take place on the property. If a person is injured on property that you own, a claim for damages may be lodged against you as a the property owner. If that claim is in excess of your liability insurance, your personal assets will be at risk to satisfy the claim. Another concern is what if your business partner dies or becomes divorced? Ownership in the property may pass from your partner, who you have a relationship with, to his or her spouse - who may be a lovely person, but not necessarily someone you want to be in a business relationship with.
How to address these problems? One course of action is to create a limited liability company ("LLC") to own the property.
- An LLC has the benefit of "pass-through" taxation - all of the property's income and losses will continue to be reported on your 1040.
- More importantly, an LLC acts as a liability shield between you and the property. As a general rule, your exposure is capped at your interest in the property. If you own 50% of property with a value of $500,000, the maximum amount of your loss is $250,000 - even if the claim is greater. Barring a bad act on your part, the LLC acts as a shield between the property and your other assets. The assets of the LLC can be used to satisfy the claim, in their entirety, but the litigant cannot reach through the LLC to you to satisfy their claim.
- An LLC is governed by an Operating Agreement. The owners, or "members" of an LLC have the opportunity in the Operating Agreement to say who will be the members of the LLC and how ownership interests in the LLC may be transferred. For example, if your partner were to die, the Operating Agreement can direct that upon the death of a member, his or her estate must sell the membership interest to the remaining members for its fair market value. There could be further restrictions in the Operating Agreement preventing the membership interest from being transferred as part of a divorce settlement or in the event of a bankruptcy, by forcing it to be sold to the remaining members if such a scenario were to arise.
Setting up an LLC is a one-time investment in your real estate. The entity must be formed, the operating agreement prepared, and a deed filed transferring title from you to the LLC. The ongoing costs might include the costs of filing additional tax returns each year and a $150 per year "head tax" in New Jersey per member where there are 2 or more members. Also, before setting up an LLC you should be aware that (i) you will need an endorsement from your Property and Casualty insurer to name the LLC as an additional insured; (ii) it may be more difficult to get an equity line against the property as you will usually need to go through the commercial lending department of your bank; and (iii) you should consider getting an endorsement from your title insurance company for the transfer of the property to the LLC.