Lawsuit Protection For Rental Real Estate

Robert J. Mintz, Esq.

Ownership of rental properties is again a popular investment strategy, Prices in many areas have appreciated substantially from the lows of the Great Recession and many view  a portfolio of apartments, office buildings, shopping centers and single family houses as an attractive alternative strategy in the current low interest investment climate.

The downside of this, from a legal perspective, is that real estate activities are a strong magnet for lawsuits and the risk from buying, selling or owning property is near the top of the liability scale.  Should you avoid real estate investment because of the high liability potential?, Definitely not.  If you feel the economics of a particular deal are sound, don’t let the asset protection tail wag the investment dog. But it does make sense to take appropriate steps to minimize the associated risks. In this article I’ll show you how we analyze a case involving rental real estate-the issues which are presented and the strategies which we have used to accomplish the proper results.

Should you avoid real estate investment because of the high liability potential?, Definitely not.  If you feel the economics of a particular deal are sound, don’t let the asset protection tail wag the investment dog. But it does make sense to take appropriate steps to minimize the associated risks. In this article in our series on asset protection I’ll show you how we analyze a case involving rental real estate-the issues which are presented and the strategies which we have used to accomplish the proper results.

Inside and Outside Liability.

The key to properly structuring real estate activities is understanding the concept of inside and outside liability.  Inside liability is a lawsuit risk that is produced by the property itself. That is, something associated with the property may cause you to be sued. A tenant can be injured on the property or you might have a dispute with a buyer or seller. A lawsuit over these types of claims creates some amount of jeopardy for your other properties and savings.  The first part of the asset protection planning is to insulate and shield you from any liability arising out of the property so that you don’t expose your other assets to this lawsuit risk.

Outside liability is the risk presented by your other activities-your medical practice or business dealings or teenage drivers. A lawsuit from any one of these sources poses a potential threat to all of your holdings, including the equity in your properties. Most commonly, clients are concerned that a lawsuit from their practice could cause them to lose their investment properties. The second objective of the planning is to protect the properties from any outside risks.

Lawsuit Risks from Real Estate

What are the risks from real estate activities? The problem that we have found is that the law treats the property owner as the guarantor of the safety of the tenants. If anyone is injured on a property-for any reason and regardless of fault-the owner will generally be held responsible. That is a big legal burden and it’s easy to see how lawsuits-frivolous or not-are easily generated in this type of system.

There is a detailed discussion of this issue in Chapter One of our book on asset protection.   But, for now, briefly we know that lawsuits and real estate are closely linked. Real or alleged injuries to tenants and their guests are regular occurrences or can be calamitous from a fire or natural disaster. Serious injury to even one person might create a potential liability exceeding the amount of insurance coverage. An apartment building  collapsed in the Northridge earthquake in 1994, and 17 people were killed. It is likely that the liability far exceeded the amount of the insurance coverage.

Other types of problems might not be covered by insurance at all. When you sell a property that subsequently decreases in value, due to a change in the market, there is commonly a lawsuit from the buyer for undisclosed defects in the property. We see this often when the housing market drops sharply as it did in the last recession. If you sell to a buyer and the market declines, the buyer will often allege that the property had numerous defects  which you failed to inform him about. These types of cases are a standard practice in the real estate business whenever there is a decline in value.

Limited Liability Companies

This inside liability, the threat of a lawsuit from a tenant, visitor, buyer, seller or lender, can usually be contained by using the correct legal structure to hold the property. Almost always, this is accomplished-at least in part-with a Limited Liability Company (LLC).

LLC’s have now been popular since the early 1990’s.  The LLC was originally conceived as an alternative to traditional corporations and partnerships. Typically, corporations protect the owners against personal liability for business activities but involve complicated tax and record keeping problems. Partnerships generally minimize the tax problems but offer no liability protection.

In response to these weaknesses,- LLC laws were proposed and adopted to overcome inherent limitations and restrictions with the then permitted legal entities (corporations, general partnerships, limited partnerships and trusts). The legal problems associated with each of these formats are discussed in detail at “Limited Liability Company – Inside and Outside Liability“.

Briefly, the key features of the LLC are:

• Owners are called members. The law specifically states that no member is personally liable for the obligations of the LLC.   That means that a member cannot be sued in connection with any matter concerning the LLC.
• You can elect the tax treatment of the LLC.  If there is only one member (or a husband and wife in community property states)  an election can be made to be treated as a disregarded entity, as if it were a sole proprietorship. Or you can elect to be taxed as a corporation (either C or S). If there are more than one members then you can also choose to be treated a partnership for tax purposes. There is no separate tax at the LLC level (like there is with a C corporation). The choice of how the LLC should be taxed should be carefully considered especially in light of the 2018 tax act. Corporate tax rates are now significantly lower than individual rates. However, LLC’s taxed as pass-through entities may be entitled to a 20% deduction. The “correct” choice of how you would like your LLC to be taxed will require some planning and thought based on your particular tax situation.
• An LLC is not required to maintain records such as minutes, bylaws or shares. Unlike a corporation, which can be legally pierced if it fails to follow the prescribed formalities, LLC law specifically states that an LLC is not required to do so.  This is a significant advantage over the corporate form of doing business since many corporations become worthless due to the absence of adequate record keeping.
• The steps that are required to create and use an LLC are spelled out in each state’s legislation. Generally there is an initial filing of the Articles of Organization with the Secretary of State. This document specifies the name of the LLC and the name and address of either the members or the manager.  Then, an Operating Agreement must be prepared which specifies how the LLC will be governed and finally the property is transferred into the LLC with a deed.

Multiple Properties

If there is more than one property the question is whether each property should have its own LLC or whether they should be grouped together. Under ideal circumstances each property should have its own LLC in order to isolate each property from the liability of each other. For example, suppose we put three properties, A, B and C, each worth $500,000 in a single LLC.  Several tenants in Property A are injured in a fire. As plaintiffs in a lawsuit they would sue the LLC which then has exposure for the equity in all three properties. Instead, if A, B and C are each in their own LLC, if something happened at property A, there is no risk of loss for the remaining properties.

This generally sound advice needs to be tempered by the real world concerns about costs and complications. Each state has an initial filing fee and a renewal fee for LLC’s ranging from about $100 to a high of $800 per year in California. In addition, each LLC may involve accounting or tax preparation fees which need to be considered. To the extent possible and affordable, multiple LLC’s for different properties is a good idea but the additional costs need to be considered.

One partial  solution to the cost and  inconvenience of multiple LLC’s is  a  Series LLC . This is a relatively new variation of the LLC,  adopted by legislation in a number of states (including Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, and Utah) with more sure to follow as the legal and tax issues are clarified by the states and the IRS.

The purpose of the Series LLC is to allow for the creation of a master LLC, which is then divided as needed into one or more separate LLCs with common or varying business purposes, governing rules, and ownership interests. The key is that each of the sub-LLCs is intended to be treated as a distinct and separate entity—each isolated from the liabilities of the other. The clear advantage is that it takes only one state filing to create the master LLC. Separate properties are then allocated to each sub-LLC of infinite number. The sub-LLC’s do not require additional filings and pay no additional fees to the state.

Series LLC’s represent present an efficient means of holding multiple properties and separating assets from the liability associated with each. If you are in a state that permits Series LLC’s and have multiple properties (or may have in the future) the Series LLC  may be a sound choice. In California, which does not have Series LLC legislation, out of state Series LLC’s doing business in California are treated as separate and distinct LLC’s.  Each sub-LLC must qualify to do business in the state and pay FTB minimum taxes.

What about protection from outside liability arising from your other business or professional activities?  If there is a judgment against you can the plaintiff seize your LLC interests? The answer is that it depends on the law of the state which is applied. In a number of states a creditor cannot force you to turn over your membership interest in an LLC. The creditors rights are instead limited to a “charging order. ” Charging orders permit a judgment creditor to take your share of any distributions from the LLC when and if distributions are made. This remedy is usually not a good result for the creditor since, in most cases, the value of the judgment is significantly diminished by the inability to obtain full and immediate payment. In Nevada, Delaware and other states a charging order appears to be the exclusive remedy of a creditor and LLC’s may provide good asset protection under those laws.

Other states allow a judgment creditor to go beyond a charging order and to foreclose on the LLC membership interest. Under California law, if a charging order is insufficient to pay the judgment, the creditor is permitted to foreclose on the LLC interest, gaining effective ownership of the membership rights. This is especially dangerous when the value of the LLC interest is greater than the amount of the judgment. In these cases the creditor will obtain a high degree of negotiating leverage and you may be forced to settle the claim on the most unfavorable terms.

There are many different strategies available for protecting LLC interests against charging order of foreclosure. Often, a Family Savings Trust provides a strong solution for protecting the ownership of LLC’s which hold rental properties and other business interests.

Rental real estate often represents a significant portion of many people’s investment portfolio. But owning and dealing in property can be a risky and lawsuit prone activity. The Limited Liability Company represents an excellent vehicle for shielding you from  inside liability. It is often worthwhile to put separate properties, each in their own LLC,  as long as the associated legal and accounting fees are justified by the value of the property. If you face any legal risks from your business or other activities it is best to protect your ownership of any LLC by using a Family Savings Trust or other appropriate asset protection strategies.

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