Updated July 7, 2020
Investing in rental real estate can be an exciting and lucrative endeavor. Particularly in our current real estate climate, renting has become an attractive option for businesses, individuals and families in the wake of the recession.
Whether you own one small rental property or many large properties, all rental real estate investors must protect themselves from liability. Liability and legal responsibilities surrounding rental properties can be confusing or intimidating, especially if you are new to rental real estate or growing your business. This, however, by no means indicates that a new investment will be an unmanageable risk. With some knowledge and a few smart steps to minimize the risk, your investment can flourish safely. A foundational knowledge of the legal landscape will allow you to take control of liability and protect against a potentially devastating situation.
Protecting rental real estate from a legal perspective requires that you build boundaries around your assets to differentiate and distinguish between them. Boundary building will protect what happens in your personal life from your professional life, and can even help to contain various assets in your professional life from each other. Choosing the best kinds of legal boundaries available is the safest and most effective way to mitigate liability overall and protect you and your loved ones from the effects of potential lawsuits.
Considering Lawsuits Specific to Real Estate
The law recognizes real estate owners as guarantors, or the responsible party for the safety of tenants, visitors and other populations associated with a property. While this recognition within the law is intended to protect the populations of people inhabiting a premise or property, it also places a significant burden and liability on the property owner. Any injury on site, regardless of fault, tends to be the responsibility of the property owner when taken to court.
While the law intends this to protect the population from inhumane living or working conditions, it can also be applied to situations that are very challenging to foresee. If, for instance, an elderly man trips over a hole in the lawn of an office building, sustaining a head injury from the fall, the liability associated with his injury may become the responsibility of the party who owns the office building. In these kinds of unforeseen instances, on site injury liability can often quickly exceed the amount covered by insurance and a property owner may suddenly find his or her other personal or private assets at risk.
Creating boundaries between assets becomes useful in managing liability. To understand how to create these boundaries, it is important to understand inside and outside liability.
Inside liability refers to the liability associated with the asset itself, or in other words, it is the risk of a lawsuit produced by a piece of real estate and the activities associated with it. Rental property will always inherently bring unavoidable inside liability with it. The dynamic nature of rental real estate increases liability and it is important to recognize just how uniquely complicated rental properties can be. This kind of business is dynamic because it involves many third parties, including buyers and sellers, as well as tenants and visitors, who all interact with the site. The property itself is also dynamic because the land, building structures and surrounding environment can all change in condition. All of these complex interactions generated by real estate creates potential inside liability that may be assumed by a property owner.
Outside liability refers to any potential risk that is not associated with an asset directly, but may threaten an asset. Most commonly, this form of outside threat comes from other parts of life or business that can become legally entangled with otherwise discrete activities. For instance, if you have a teenage driver who is at fault for a vehicular accident, the court will consider all assets for which you are the owner or proprietor in order to fulfill the financial responsibilities associated with the accident. Outside liability can be particularly threatening because we cannot predict exactly where it might arise from.
Here’s the good news: You are in control of what assets are susceptible to outside liability and how you contain assets. This means you can utilize the law to protect your assets and keep inside liability inside and outside liability outside.
Creating strong boundaries
Are Land Trusts Useful?
The most common and permeable property boundary recognized by the law is a land trust. A land trust may be an attractive option at first because it has a few enticing benefits, but is likely not the best option for rental real estate owners.
Simply speaking, a land trust means that the owner of a property transfers the title of a property to another party. The property owner maintains the overall management of the land, directing the trustee in all matters of affairs. This allows the property owner to remain anonymous while maintaining the ability to develop, sell and rent the property. To the public eye, however, the trust itself is listed as the holder of the property.
Land trusts are commonly used to maintain anonymity by wealthy land owners in purchases or corporations looking to buy large tracts of land for future development. This is commonly referred to as an “Illinois Land Trust.” Other forms of land trust include conservation land trusts or conservation easements, which are utilized to protect land from development or pollution.
A trust agreement can articulate the parameters of development or use, making it a reasonable legal avenue for land protection. One last form of land trust is a community land trust. This type of land trust is commonly used by non-profits or entities seeking to manifest low-income housing. This type of trust allows individuals to purchase a structure on a piece of land without purchasing the land itself, thereby decreasing the buyer’s overall purchasing cost.
Land trusts are economically attractive. In many states, land trusts are significantly cheaper than establishing an LLC or other form of protection. Additionally, land trusts have fewer specific regulations and are regulated under the state’s guidelines for trusts more generally. Individuals often find this freedom enticing because of its flexibility under the law.
This option, however, comes with a price. While land trusts may achieve some legal separation between you and a property, as well as anonymity from the public, they are more easily traced to their guarantor—the original individual who established the trust. This means the level of legal protection is minimal to potential outside liability. In the case of a lawsuit, a land trust may be considered a revocable trust and the guarantor may be responsible for giving up the property.
LLC’s and Rental Real Estate
A better option for creating appropriate legal boundaries between your assets is the use of an LLC. This option is often a greater financial investment, but much safer in the case of a lawsuit.
An LLC, or limited liability company, is a relatively new legal business distinction that incorporates some components of a partnership and some components of a corporation. LLCs are governed by ‘members’ who, like in a corporation, are not held personally responsible for debts or liabilities of the company. This is key in protecting rental real estate from potential lawsuits. Additionally, LLCs are recognized like partnerships under tax law. This is substantially less financially cumbersome and costly compared to corporations.
By investing in real estate as an LLC, you will successfully detach your personal assets from your rental real estate. When your LLC owns your rental real estate, you have effectively placed that property under the legal responsibility of the LLC, not you as an individual. Ultimately, this means you have created a safe boundary between your private life and the business associated with your rental real estate. The outside liability associated with your teenage driver now stays limited to your personal assets and the inside liability associated with your rental real estate is contained within the LLC.
LLCs and Multiple Rental Real Estate Sites
It may be even more useful to your business to create multiple LLCs associated with each rental real estate property you own. One of the issues with outside liability comes about when a lawsuit associated with one real estate site effects a second property or multiple sites.
If water damage on one site far exceeds what insurance can cover, for instance, you may be required to use other assets available within the LLC to cover that liability. By establishing multiple LLCs, you are containing the liability of each site to itself, thereby mitigating the overall financial effect of a lawsuit.
Creating separate LLCs for each property is a financial investment and can be a limiting factor for some. Ideally, multiple LLCs will create the greatest protection between inside and outside liability, but you will have to determine if the mitigated risk is worth the financial investment.
A new legal option in a number of states is a series LLC. A series LLC, or SLLC, operates fairly simply: An umbrella LLC holds a number of other “series” under it. Each series acts autonomously, essentially as its own LLC, and as a liability container. This separates the liability associated with that rental real estate property from the liability of any other series.
The great benefit of this model is that while it works to contain liability, it can be substantially less expensive because it is recognized as one taxable LLC. States that have recognized this distinction include Alabama, D.C., Delaware, Illinois, Indiana, Iowa, Kansas, Missouri, Montana, Nevada, North Dakota, Oklahoma, Tennessee, Texas, and Utah, Wisconsin, Wyoming and Puerto Rico.
You Have Control
As a rental real estate owner, you have a lot of control over limiting and mitigating the effects of potential lawsuits. By creating strong boundaries that differentiate between your precious assets, you can effectively contain inside liability and protect against outside liability. In the event that a lawsuit does arise, you can protect yourself and your family from devastating financial losses.
For guidance and assistance in choosing the best structure for your business and limiting your personal assets’ exposure to liability, contact our team at Anderson Advisors for a consultation today.
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