Owning investment real estate can be a very rewarding and profitable experience, but it can also be a huge headache and a drain on resources. Having recently purchased my first investment property, my head is filled with conflicting images of myself sunbathing on my private island or lying penniless in a gutter. The possibilities and the liabilities seem endless.
While real estate is often a great way to store wealth and create streams of passive income, it does come with a myriad of strings attached. Unlike stocks or bonds, real estate often requires a “hands-on” approach and exposes an owner to significant liabilities. Here is a sampling of situations where an owner may incur liability for their property:
- A tenant trips and falls down a flight of stairs due to a defective handrail
- A tenant’s child drowns in a pool which isn’t adequately fenced off
- A branch on a tree on your property which isn’t adequately trimmed falls on a third party’s car
- An environmental survey reveals significant contamination on your property which needs to be remediated
These are all situations which could involve a lawsuit or a claim against your insurance. In certain examples, the liability may be so great that insurance doesn’t cover it, allowing the injured party to come after your investment properties or even your personal assets. The question here is “how do we reduce this risk?” In an estate planning context, our goals for investment real estate are to:
- Protect ourselves from liability while we are living;
- Preserve our assets to maximize what we pass on to our children or other beneficiaries;
- Make it as easy as possible for this transfer to occur upon our passing.
One simple and relatively inexpensive way of reducing the liability on investment property is by purchasing an umbrella policy. An umbrella policy is a policy that provides additional coverage above and beyond your primary policies. For instance, if you have insurance on your investment property for $300,000 and an auto policy with limits of $500,000, a $1,000,000 policy will increase those limits $1,300,000 and $1,500,000, respectively. This provides a greater cushion in case you incur significant liability.
Another way to protect yourself is by creating a limited liability company (LLC) to hold your real estate. An LLC is a legal entity that provides significant benefits to its members. The primary benefit is that the liability of the owners of the LLC is limited to the assets of the LLC and does not extend to the personal assets of the owners. By holding your real estate in an LLC, you can compartmentalize your liability to the assets in that LLC. Let’s say that a tenant unfortunately falls down that flight of stairs we mentioned earlier, suffering severe injuries. In that case, the tenant can only go after the property held in that LLC. He can’t get at your personal home or other investments that you have outside of the LLC. If you have multiple properties, you can create multiple LLCs to maximize the amount of protection you have.
Another benefit of LLCs is that they can be seamlessly blended into an existing estate plan. It is relatively simple to transfer LLCs into a living trust to allow your loved ones to manage things in the event of your death or incapacity. Furthermore, as you acquire more assets and build your net worth, you may want to start transferring some of your assets to your children to reduce your estate tax liability. Transferring fractional shares of your LLCs is not only a easy way to make gifts to your children without losing control of your real estate, but it also allows you to qualify for significant valuation discounts from the IRS when calculating your estate taxes.
Brian Y. Chou, Esq. is an estate planning attorney based in Southern California at the Law Firm of Barth Calderon, LLP.