Over 100 million lawsuits are filed in the U.S. state courts each year, including people suing for personal injuries. That last thing that a landlord wants is to have a real portfolio that has taken so long to build up be used to pay for damages agreed to in a settlement or awarded in a lawsuit. There are, however, measures that a landlord can take to protect their assets.
- Real estate protection strategies are used to protect business and personal assets from creditor claims.
- By using a combination of asset protection strategies, an investor may be better able to limit risk to a single asset.
- Strategies to protect real estate assets include purchasing landlord insurance, forming an LLC, and using debt to limit the amount of equity that may be at risk.
What does real estate asset protection mean?
Real estate asset protection is a strategy an investor can use to help protect properties, along with other business and personal assets, from creditors or plaintiffs who win a judgment in a lawsuit.
For example, imagine that a tenant or guest of a tenant is injured on the property and decides to sue a landlord. If a judge rules in favor of a tenant, a landlord may have to pay a tenant’s medical bills, legal and court fees, and compensate the tenant for lost wages and emotional distress.
Damages like these can add up to a large amount of money, even if the case is settled out of court. By having a proper real estate asset protection plan in case, a landlord is better able to separate personal and business assets from one another. This may help to limit the specific assets that a landlord can be forced to liquidate to pay for a settlement or judgment.
6 strategies to protect real estate assets
Here are 6 strategies used to protect real estate assets. Because every investor and financial situation is different, a landlord may wish to consult with a financial planner or legal advisor when developing an asset protection plan.
1. Landlord insurance
Landlord insurance provides coverage specifically for owners of rental property. As a rule of thumb, a landlord insurance policy will provide protection from the following losses:
- Liability coverage protects a landlord if someone is injured on the property and decides to sue. Potential costs could include bodily injury and emotional distress claims, medical fees, loss of income due to injury, funeral costs, and legal and court fees.
- Property damage covers damage to the home and any outbuildings (such as a free standing garage) from damage caused by a fire, natural disaster, or theft. A landlord’s personal property used in the rental – such as kitchen appliances, power tools, or landscaping equipment – may also be covered in the event of damage or theft.
- Loss of rental income from rent not received if a tenant has to temporarily relocate when a damaged property is being repaired. For example, if a tenant’s rent is $2,000 per month and a tenant has to live someplace else for 6 weeks, a landlord may receive $3,000 in compensation for lost rental income, after paying the policy deductible.
Some investors also choose to get extra insurance coverage through an umbrella policy.
2. Limited liability company
A limited liability company or LLC is another common strategy a landlord may wish to consider to protect real estate assets. An LLC is a legal business entity that holds a property and pays the operating expenses and mortgage.
By forming an individual LLC for each rental property, other business and personal assets are protected from claims, because a creditor is generally limited to only the asset held in an LLC.
For example, assume a landlord owns 3 investment properties worth $250,000 each. In the event of a lawsuit, $750,000 of real estate might be at risk. On the other hand, if each rental property is placed in a separate LLC, the potential risk would be limited to $250,000 less any debt on the real estate.
3. Real estate trust
Holding property in a trust may also help to protect real estate assets, as well as to provide privacy.
Since property is held in the name of a trust and not an individual, it may be more difficult for a creditor to discover who the owner of a property is. In addition, if there are multiple owners, holding the property in a trust will protect the property if one of the owners should have a judgment since the creditor or judgment holder cannot go after trust assets. Oftentimes an investor may create a revocable trust to have more control over the property as market conditions change.
In addition to providing asset protection, transferring real estate into a trust is typically easier than with an LLC. Holding real property in a trust can also simplify estate planning by naming beneficiaries to avoid probate.
4. Avoid risk
Avoiding excessive risk is another technique an investor may use to protect real estate assets. For example, implementing a thorough tenant screening process, reviewing a credit report, and speaking with an applicant’s references may reveal if a prospective tenant has ever been involved in a lawsuit.
Asking contractors and handymen for references and proof of insurance is another way to avoid risking situations that may put a landlord at risk. If a contractor is uninsured and is injured or harms a tenant, a landlord may be found liable for medical bills or other damages for putting a tenant at risk.
5. Strategically use debt
Also known as “equity stripping,” debt is another way to help protect real estate assets. To illustrate, imagine that a landlord owns a $100,000 rental property free and clear. That $100,000 of equity represents a lot of money that could quickly become a big red target for a plaintiff’s lawyer.
However, if a landlord strips the equity out of the property and maintains a loan-to-value (LTV) ratio of 75%, the potential amount of cash at risk is reduced to $25,000. A creditor or attorney may decide that a few thousand dollars isn’t worth the time, trouble, and expense to pursue.
6. Homestead exemption
While a homestead exemption is one of the most straightforward ways of protecting a real estate asset, it only applies to a primary residence. Homestead laws allow an owner to register a property as a homestead, making the asset unavailable to most creditors.
Some states such as Florida and Texas protect unlimited value of a homestead property, while others have statutory limits. The legal resource website FindLaw publishes a page with links for state-specific homestead laws.
What about a Nevada or Wyoming LLC to protect real estate assets?
Both Wyoming and Nevada are frequently touted as two of the best places to form an LLC. There are no state income taxes, asset protection and privacy laws are strong, requirements for an operating agreement and annual shareholder meetings are minimal, and forming an LLC in both states is quick and inexpensive.
However, many of these benefits may only apply for an LLC that owns a rental property located in Nevada or Wyoming. That’s because an out-of-state or “foreign” LLC is governed by the laws of the state where the property is located. For example, if an LLC registered in Nevada owns a rental property in Georgia, the LLC will be governed by Georgia law.
An investor will also be required to pay taxes in both states (although most states have reciprocity agreements to avoid double taxation), and pay annual fees to keep the LLC active in both states.
Real estate asset protection vs preservation
The words “protection” and “preservation” are sometimes used interchangeably, but they really mean two different things. Strategies for protecting real estate assets are what we’ve discussed so far, such as purchasing a landlord insurance policy or holding property in an LLC.
On the other hand, real estate preservation generally deals with how to minimize taxes and preserve assets so that they can be passed from one generation to the next rather than selling. By holding real estate in a trust, an investor can avoid a costly and lengthy probate process and will give a property directly to a selected heir.
When a property is inherited, the cost basis is stepped up to the current fair market value, reducing the amount of taxable gains when and if a property is sold.
Selecting the right combination of strategies may help an investor to protect real estate assets from creditor claims, liability, and lawsuits.
Many of these real estate asset protection strategies, such as purchasing a landlord insurance policy and maintaining a conservative amount of debt, are things that most real estate investors already do.
By adding an extra layer of protection by holding real estate in an LLC or trust, an investor may be better able to protect the personal wealth that has taken so much time and effort to build.