In the real estate investment business, we talk a lot about risk management. Much of the time, this is relegated to concepts like portfolio diversification, insurance, and savvy business decisions. One of the things we don’t always talk about, however, is asset protection.
I think this is because asset protection is where things start sounding overwhelming and complicated for new or inexperienced investors. Do I really need to fool with all of that? Is it really necessary?
So many real estate investors ignore protecting their assets through an LLC because it seems like a headache. It comes with changes for your taxes, it seems difficult to understand, and why do you even need it?
Here’s what you need to know about protecting your assets through an LLC.
Everything Real Estate Investors Need to Know About Asset Protection Through an LLC
How Does an LLC Protect My Assets?
An LLC (limited liability corporation) is a method of shielding yourself personally from someone who tries to take legal action against you. When you have deep pockets and a wealth of assets, you will find that there are people who want to take advantage of that.
When you set up an LLC, it acts effectively as a barrier between you personally and the person who is trying to take your assets from you via legal action (namely, suing).
So, How Does an LLC Help Real Estate Investors?
Let’s present two imaginary scenarios. We have one investor who has $10 million in assets and he operates without an LLC—he holds all of his properties personally. Another investor, also with $10 million in assets, has an LLC that holds a small portion of those assets.
One day, they each have a disgruntled resident who finds a good enough reason to sue. What’s the difference?
The owner without an LLC is sued personally and that tenant is coming after his personal assets. There is no barrier between that tenant and that full $10 million in assets.
The owner with an LLC, however, is shielded to a degree. That tenant can only come after the holdings within the LLC in most cases, while the rest of the owner’s assets are safe. An LLC is a containment strategy—it limits liability. People who sue an LLC can only come after the amount of money that an investor has put into that LLC.
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What Every Effective LLC Needs
Protecting your investments and assets is not as simple as forming an LLC and leaving it at that. You have to constantly manage your risk if you want to avoid frivolous lawsuits and unnecessary loss. There are certain things you must do to properly manage an LLC to truly benefit from its protection.
Insure your LLC.
This is probably the biggest point to hit on. Many investors make the mistake of forgoing LLC insurance because of the cost. It’s important to remember that your LLC doesn’t 100% protect you from a potential lawsuit if that lawsuit targets you personally. Your personal liability still exists, and it’s important to be insured for that reason. Even though your LLC exists to protect your personal assets, you still don’t want to lose the assets you’ve invested into your LLC if it can be avoided.
Get insured to protect yourself and your business as much as possible.
Maintain an independent entity.
This is one of the biggest mistakes that people with LLCs make. One thing you have to wrap your head around is that an LLC is designed to be a separate entity. Signs point to the notion that LLCs are beholden to something in the corporate shareholder world called “alter ego liability,” which means that your personal assets cannot mix or mingle with your LLC’s assets.
You need separate bank accounts, credit cards, records, signatures, invoices, purchase orders, contracts...so on and so forth. What’s important is that people know they are dealing with your LLC and not with you as an individual. Your LLC must take on a life of its own rather than existing as your prop or puppet. Think of it like a real business.
Keep “just enough” associated with your LLC.
Remember that your primary goal for your LLC is to limit your liability. You do this by keeping the monetary association with it low. Unlike an LLC formed to start a real business, you have formed it as a vehicle to limit your risk.
However, you do have to reverse a commonly expressed bit of financial wisdom. Rather than paying yourself first, you have to satisfy your LLC’s debts first. Pay off any creditors, bills, mortgages, employees, etc., before you send money back to yourself as owner. This will prevent anything from being seen as fraudulent.
Grow your LLC credit.
Remember, your LLC is a separate entity. This isn’t just in the eyes of the IRS or the court system. This is for the bank, too. That means when it comes to buying new properties or other major purchases, you’re going to need to have good credit associated with this entity. Otherwise, you will have to get personally involved and guarantee to pay for something if your LLC cannot. You will have to lend your good credit and good faith in your LLC's stead.
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You do not want to take on personal liability. Creditors can then come after you and your assets down the line. While you may have to do this initially as your LLC grows good credit, put a stop to it as quickly as you can.
As your assets grow, take the steps to protect them. While you may think you will never face a lawsuit or that you’ve managed your risk well enough on your own, it’s always better to be safe than sorry. It’s far better to be over-prepared than to be blindsided!
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