Attention New Investors - Asset Protection Simplified

[Stuart Udis]

Attention new investors: As I’ve immersed myself in the BiggerPockets forums, I’ve observed an extreme emphasis placed on asset protection by those entering the business but their approach and where they decide to allocate their time and resources is misplaced. This is causing unnecessary distractions and taking away from your ability to focus on the action items that matter most: building meaningful industry relationships and sourcing investment opportunities. I decided to post my thoughts in the “Starting Out” category hoping to get your attention knowing there are service providers waiting in the wings ready to take advantage of your unfounded beliefs and further upsell you through scare tactics. Here’s what you should know:

1. You should purchase non owner occupied real estate in an LLC. More than anything this will exclude you personally from claim history (some of which is without merit and is the nature of the litigious society we live in). This could also open the doors to direct equity investments in the future if you scale and continue to hold these initial assets. Some may argue it's not necessary at the start, but it becomes costlier to transfer a property held in your name to an LLC at a later time and this is good forward thinking business planning.
2. Don't worry about forming an LLC until you execute an agreement to purchase real estate. You can incorporate language into the sales agreement that allows you to form an LLC and take title in that LLC as a closing condition. Just remember to notify your lender and the title company and disclose to the lender who will be the members and guarantors before the loan is underwritten.
3. In most cases, form the LLC in the state in which you live or the property is located. Speak to your accountant to confirm the best option for you.
4. Anonymity is not asset protection. Forming an LLC in a specific state believing you will be better protected is not true and will not prevent claims from arising.
5. Understand insurance and make sure you have the appropriate types of insurance depending on the investment opportunity you are pursuing whether it be land, a construction project, a tenant occupied property etc.. The types of coverage will change accordingly.
6. Make sure every vendor who performs services on your property or on your behalf maintains appropriate contractual relationships whether it be directly with you as the owner or with an intermediary such as a General Contractor or Property Manager. Similarly, make sure all of these transaction participants maintain adequate insurance and list you, the property owner and any intermediary as additional insured.
7. If you rely on an intermediary relationship (most commonly a General Contractor or Property Manager), understand the authority granted in any agreement you execute to act on your behalf.
8. Review the indemnification provisions in any service agreement ensuring the standard of care will not preclude insurance coverage and the provision is equitable.

To recap, it's not necessary to form a land trust, separate management LLC's or form entities in specific states believing you will hide in the cloaks of secrecy. Most of what I shared are proactive measures you can take to greatly reduce your liability exposure and shield you from a host of claims that commonly arise in real estate. If you believe I am oversimplifying this, I am not. In fact, what I just shared is the playbook for a $1B real estate portfolio I previously counseled as an attorney and mirrors how most other similar portfolios operate. Meanwhile your peers who own $100K houses in Detroit (no knock on Detroit, just used for illustration purposes) feel the need to create a convoluted web of entities and ignore most of what I shared. Don't be like them. As I shared initially, if you have not purchased your first property, focus on building your industry relationships and deal sourcing. Once you've purchased your first property be proactive, mindful of your vendor relationships and intentional with how you operate your business. This will keep you personally protected and allow you to run your real estate business far more effectively.

[Stuart Udis]

@Scott Mac You raise some good points and open the door for some additional dialogue. First, I don't believe a real estate investor should own all of their property under one LLC. Can you own a few single family homes or smaller multi's? Yes. It is otherwise inefficient to operate. Of course if there are different LP partners that will necessitate separate entities, even if the underlying assets themselves don't justify the need. Lenders will be vocal about their comfort level with issuing a loan when there are multiple properties owned through a single LLC, particularly if the portfolio is financed through multiple lenders and that threshold can vary depending on each lenders internal standards. However as a general rule of thumb when the lenders begin to nudge you when you are operating smaller assets single LLC's, its usually time to begin acquiring in a separate LLC.

I don't want my comment about having separate management LLC's to be construed as having separate deed holder LLC's. That comment specifically relates to the investors who believe they are better protected by having a separate LLC collect rent and perform management functions independent of the deed holder LLC. This offers no additional protection, adds additional operating expenses and is treated in court as an alter ego entity. There are instances where a separate management LLC does make sense, but these investors are nowhere near the point where their operational level to warrant this.

To broadly cover your other points about being individually named as a defendant as well as going after the LLC's assets I believe its helpful to understand the true objectives of the plaintiff's attorneys pursuing claims against these investors. More than likely they are working on a contingent fee basis because the plaintiff does not have the means or alternatively would rather part with some of the upside for contingent fee representation. This means the plaintiff and their counsel only gets compensated if there is a settlement/jury award that gets paid out. The last few words are critical because a judgment entered against a plaintiff or even a settlement for that matter where no insurance carrier is involved does not guarantee compensation. This is why you customarily see plaintiffs attorneys take inventory of all parties who can be brought into claims and focus primarily on what insurance money can be made available. 

This is also why its important as a property owner you maintain proper contractual relationships and manage insurance certificates correctly with your vendors. More times than not the person responsible for any claim that arises that's not financial related is a vendor who performs work on your behalf or on behalf of the property & keeping these vendor relationships in order can greatly reduce the need to fully rely on your own insurance policies. 

As for being named individually, while the standards will vary it is generally very difficult to pierce the corporate veil and comingling the funds is the most common culprit. This is why its important to operate your LLC as a business and follow the operating agreement. The rules and procedures of your operating agreement and your ability to follow the agreement is far more important than the actual state specific filing docs. Most plaintiffs attorneys won't name the LLC member individually unless there is a clear and convincing fact pattern that points to piercing the corporate veil. Are there aggressive attorneys who will name plaintiffs without any true merit? Sure. However this is the minority, and that same aggressive minority will likely make the argument to bring the plaintiff in individually as an additional named plaintiff if the name is not readily available when the claim is first submitted once they go through discovery. Another way of saying anonymity is likely not going to help much anyway when dealing with this minority plaintiff attorney you hope not to encounter and most never will.

I believe the second half of this post really speaks to the mechanisms and practicalities of litigation and should point to how you should operate your business to avoid such claims from arising but if they do, what should be done through your day to day operations to mitigate your personal and business exposure. As you can see the emphasis on anonymity, and management LLC's aren't going to really change the outcome and following through on the suggestions from my initial post is the best course of action.