The Downside To Buying Rentals With an LLC
But should those properties be purchased using an LLC?
“Perhaps”, says expert Jason Watson, with the Watson CPA Group in Colorado Springs, Colorado.
Watson says there are several myths out there regarding the use of an LLC as a shelter from potential lawsuits and litigation. While consultation with an experienced attorney is strongly recommended for each unique situation, as rental property consultants, the Watson CPA Group feel that the excitement of the LLC has overshadowed the reality of a litigious society, lulling investors into a false sense of security that they will not be held personally liable, regardless of their actions with the rental property.
For instance, if a property owner fails to maintain the rental in a proper and safe condition, there’s a good chance the owner of the LLC will be personally named in the lawsuit and held liable if someone gets hurt, Watson warns. The same may be true of discrimination claims. Officers and directors of corporations are occasionally held criminally liable for the wrongful actions of the corporation. This is called piercing the corporate veil — Enron anyone?
Piercing the corporate veil is typically most effective with smaller, privately held business entities — close corporations — in which the corporation has a small number of shareholders or limited assets, and when separating the corporation from its shareholders would promote fraud or an inequitable result.
Consider that a two-member LLC which owns rental properties would easily be considered a close corporation. And if those members were grossly negligent in the way the LLC managed the rental properties, separating the corporation from its shareholders would certainly not promote fairness from a liability perspective.
On the contrary, if an investor owned shares of Ford Motor Company, he or she was not personally responsible for the damage caused by the Ford Pinto, Watson, explains.
Furthermore, if an investor owns multiple properties and thinks he or she can protect other assets in the event of a lawsuit against one, think again. In the Watson CPA Groups non-legal opinion, if a landlord faces a credible lawsuit arising out of negligence there is a chance everything he or she owns is going to be pursued by the injured partys attorney including personal residences, cars, college funds, LLC assets, etc.
The firm strongly recommends that in addition to forming the LLC, an investor secure a decent umbrella insurance policy both at the personal and commercial level for liability arising from injuries on residential properties. It appears that many lawsuits settle with payment of the coverage limit to avoid lengthy and expensive litigation.
An investor might also consider having tenants sign Hold Harmless Agreements, Watson suggests. Again, please consult an attorney for each unique situation.
More importantly, keep your rental in proper working order, Watson advises — tight railings, shoveled sidewalks and driveways, cooler hot water temperature settings, newer tempered windows, carbon monoxide detectors, fresh fire extinguishers, etc. Dont give a jury the chance to attach the “slumlord” label to an investment.
Having said all that, it is not a bad idea to have an LLC own a rental property, Watson says. In fact, it may be necessary for proper accounting, like when multiple investors are teaming up. Then, an LLC with a solid operating agreement might be the only way to properly handle the ownership.
But it’s important to remember that the LLC is not designed to be a substitute for reasonable care in day-to-day property management of every rental property investment.
Since 1997, The Watson CPA Group, a progressive tax consultation and preparation firm embracing Internet technology to provide worldwide tax service, prepares individual and corporate tax returns for a flat fee, and specializes in LLCs, small business and corporate taxes, pilot and flight attendant tax deductions, rental property owners and expat tax clients.
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