When buying your first rental property, you may get all those giddy feelings: excitement, anticipation, and high hopes… And then you talk to someone who's done it before, and you start to hear all the caveats – your tenants might not pay on time, they might damage the property, or something bad can happen and they may drag you into court.
If you ask around how to prevent that last scenario, you might hear that a limited liability company (LLC) is the answer: all you have to do is include an LLC in your rental property business plan, and you're covered!
So, is that how it works, is it that simple? The answer is that, as with most legal issues, it's not. As I'll explain, an LLC does offer a lot of protection, but it's not some impenetrable shield that you can put up and be done with it. So, let's see how it works.
Does Buying Rental Properties With an LLC Really Protect You?
What is an LLC?
As a matter of general concepts (not legal advice– see the disclaimer below), an LLC is a limited liability company. That means that it's an intangible entity that the state allows you to create, and which can do business (including all sorts of rental property investment and buying rental property).
To see how this works, let's take an example. If you buy some clothes at Old Navy, who are you buying them from; who are you paying? Is it Joe the cashier, or is it Old Navy? Joe will not take your money and deposit it into his personal bank account. Rather, it's Old Navy that you're doing business with.
So, when you set up an LLC, you are creating a company that can do business as its own “person”. You can then transact business on its behalf, as its employee or agent. At the same time, you can be its owner or part owner, which in many states is called a “member”. (In the case of corporations, the equivalent concept is a shareholder).
What Can an LLC Do?
In general, an LLC can transact any and all kinds of business, through its employees and agents. In terms of rental property investment, LLCs can own property, including real estate. So, in other words, if you set up an LLC and buy a house, the house will belong to the LLC, and not to you personally. You can take this concept as far as you want. For instance, you can have one LLC that becomes a holding company and owns other LLCs, which each own one piece of real property.
In that example, it would look something like this: you and your partners are the members of Mega Holding, LLC. Mega Holding, LLC, is the sole member of Landlord LLC 1, which owns Apartment A. Also, Mega Holding, LLC is the sole member of Landlord LLC 2, which owns Apartment B, and so on and so forth. (I'll explain soon why you might want to do this).
How Does Buying Rental Property with an LLC Protect You?
In short, buying a rental property with an LLC should protect you against what other people do, but not against what you do. I'll show you what I mean.
How an LLC Does NOT Protect You
So let's say you're buying your first rental property, and you go ahead to create an LLC and use it to purchase an apartment. You put it on the market and soon get your first tenants, a nice couple with a baby. A few months in, the washing machine breaks down, and they ask you to fix it. Since you're handy, you go over there and fix it yourself; however, you make a mistake. That night, your mistake causes an electrical fire, and your tenants get hurt.
Will your LLC protect you (personally) from a lawsuit? No. Remember, it's not a liability shield – it's a limited liability company. As a general legal concept, you are always liable for your personal fault or negligence, regardless of your relationship to some entity like an LLC.
How an LLC DOES Protect You
Protection from Personal Injury Lawsuits
Now, let's imagine a different scenario. Say that, instead of fixing the appliance yourself, you hire a licensed repairman. Said repairman fixes the washer, but makes the same mistake and causes the same fire. Will the LLC protect you? Yes. The repairman can get personally sued, as can his employer, as well as (possibly) your LLC. However, you, personally, are protected. (Note, however, that if you were negligent in hiring an unlicensed or unqualified repairman, you may still be liable).
But, even if you're safe, your business may still be in trouble, since a successful lawsuit against the LLC can mean that its assets (the apartment) can be seized.
(This, by the way, is why it can be a good idea to have one LLC for each rental property, under the umbrella of a big, “holding” LLC. If one LLC is successfully sued, it can lose its assets, but it likely won't affect the other companies. In contrast, if one LLC owns multiple properties, a lawsuit due to a problem at one of them can result in all of the properties being seized).
Protection from Creditors
Another facet of LLC protection is the protection from creditors. That means that if an LLC takes out a loan and then doesn't pay, the creditor can only go after the LLC, and not its owners (members) personally. The problem with this is that, for new small businesses, this is mainly a theoretical matter. I say this because, unless the LLC is an established company that's been in business for a while, chances are that any lender will ask you to personally guarantee a loan. Therefore, if the LLC doesn't pay, the lender can go after the guarantor (you) personally.
If you can get a mortgage under the LLC when buying your first rental property and don't get asked for a personal guarantee, great. I just don't know how often that happens in reality.
General Rule on LLC Liability Protection and Rental Property Investment
Coming back to personal injury liability and as a general rule, an entity like an LLC or a corporation protects you from being held liable for what other people do. If they are acting as agents or employees of the LLC, they will be held liable, as will be the LLC. But you, personally, will not. Regardless of this, you can always be held liable for what you do (or fail to do) yourself.
And like I said, “what you do” can include failing to hire qualified people to do work. If you need to hire a repairman, you need to do it responsibly. If you just pay some random, unqualified person to do something and they do it wrong, you can probably still be held personally liable.
How to Protect Yourself When Buying Rental Property
By all means, include an LLC in your rental property business plan. But, also, do two other things: get insurance, and follow good practices.
Get Great Insurance
In real life (as far as I've seen) insurance companies handle most lawsuits. If you or your LLC are well-insured and get sued, the insurer will hire lawyers to defend you (called the “duty to defend”) and will pay any judgment up to the limits of the policy.
That's why I think the most critical thing you can do in terms of asset protection is to be well-insured. Buy a good policy with a good company, plus a solid umbrella or excess policy. A competent insurance agent should be able to find you a good commercial policy to fit your needs.
Follow Good Practices
Once you are insured, read the policy, and follow good business practices. Hire a well-qualified property manager or repairmen. Don't cut corners! Even if you're insured, cutting corners (like, for example, hiring unlicensed people to work on the property) could make your insurer deny a claim, and leave you on your own.
Always follow the law, hire licensed people, and get all proper permits. That way, you'll (A) prevent many issues in the first place, and (B) avoid getting dropped by your insurer when there's a claim.
Also, licensed, responsible repairmen will be insured themselves (and you should ask for proof of such insurance). That means that, in the event of a lawsuit, what will probably happen is that their insurance company will handle it, and your LLC won't be involved at all. (Whether your LLC would be “suitable” in a situation like this is a complex legal matter that can vary depending on the state and the circumstances).
I've put together a diagram showing a sample scenario, where your LLC hires a licensed and insured repair company to fix an appliance, but the repairman makes a mistake and causes a fire:
Summing It Up
Contrary to popular belief, an LLC does not make you lawsuit-proof. It makes you somewhat “lawsuit-resistant”, regarding the problems that other people cause. However, in my view, the best asset protection for someone interested in rental property investment probably includes three parts. First is an LLC, second is great insurance policies, and third are good practices.
Here's to your success!
Even though I am a lawyer, this is not legal advice. It's a discussion of general legal concepts. Laws on business entities and liability are complex, can vary from state to state, country to country, and can and will change. Therefore, if you need legal advice, I strongly suggest that you consult a lawyer who practices law in your city or state. Again, talk to a lawyer before taking any action.
Sources: My own legal training, NOLO