Although real estate is a common investment, few real estate owners have implemented the proper legal structures to get the most out of their investment. As a result, they expose themselves to unnecessary lawsuit risks and pay far too much in unnecessary taxes on their real estate. This article can show you how to own real estate so that you may be able to protect yourself from real-estate-related lawsuits. Perhaps most importantly, the proper structure could more than pay for itself through the tax savings you may realize.
The types of real estate we are referring to include rental residential or commercial properties, the medical practice building, or even raw land. The merits of real estate as an asset class are beyond the scope of this article, but the structure needed to most efficiently benefit from these holdings is universal.
As doctors learn in medical school, “first, do no harm;” the same concept can be applied to real estate investing. The last thing you want to do is invest in an asset that generates a lawsuit which threatens your other wealth. Each year, millions of lawsuits are filed against the owners of real estate throughout the U.S. They are brought by lenders, tenants, guests, lessees and even trespassers. Let’s look at an example of a real estate lawsuit risk:
Rob the Real Estate Owner is Victimized
Rob owns several apartment buildings. He owns some in his own name and some in his wife’s name. The total value of the real estate is $4,000,000 and there is about $2,000,000 of debt on the properties. The rental income more than covers the debt service and Rob and his wife make a nice monthly profit. Rob also has a beautiful home worth approximately $1,500,000 with a mortgage of about $500,000.
After an unfortunate event at one of the properties, Rob was named in the lawsuit. Though Rob wasn’t even on the property at the time of the event, Rob ultimately lost a judgment for $3,000,000. His liability insurance covered $1,000,000 of the loss, but he had to come up with $2,000,000 himself.
This left Rob with a dilemma. Sell all of his real estate properties and mortgage his house for the remainder of the settlement or sell his house and further mortgage his real estate at relatively unattractive loan rates. In either case, Rob was unhappy about the consequences as both options resulted in a loss of the equity he had built over 20 years. In the end, Rob lost his rental properties and his home. Although he didn’t lose his ability to spot a good real estate opportunity, Rob was reluctant to re-enter the real estate market after this ill-fated experience.
What Could Rob Have Done Differently?
If Rob had gotten the right advice, he could have done a few things to protect himself. Here are a few options:
Review Property and Casualty (P&C) Insurance
In this case, Rob did not have adequate insurance protection. Had he had the right coverages and limits, either through a “slip and fall” type policy, landlord insurance, business umbrella or other coverages, his personal liability might have been severely reduced, or even eliminated. Also, such coverages can be extremely inexpensive, given their high coverage limits. This is one reason we make a P&C insurance review part of every asset protection planning engagement.
Separate Properties into LLCs
A limited liability company (LLC) is a legal entity that affords both inside-out and outside-in protection. In other words, if you had one LLC for each piece of property, a lawsuit arising from one property could only threaten the equity in the property inside that LLC. The judgment would not extend to the assets in other LLCs. Further, if Rob had been sued personally for an accident, for malpractice (if he were a doctor) or for any other personal claim, the LLC would provide a high level of protection from that lawsuit even though Rob and his family own all the shares of the LLC. This is a popular strategy for real estate owners in the U.S.
Separate LLCs with Management Company
To take the above strategy to the next level, many savvy real estate owners use a management company to manage the LLCs that own properties. This technique can provide significant tax and retirement advantages, as the management company can be structured as a different type of tax entity from the LLCs. This allows the owner to get the “best of all worlds” in terms of the taxation of the entities involved. One benefit the management company can provide for the physician investor is to sponsor qualified or non-qualified retirement plans. These plans can often be layered on top of existing retirement plans at the business level, may not require contributions for employees, can reduce the taxes on income generated from real estate, and can ultimately increase retirement income for the owners.
If you now own significant real estate, or plan to in the future, you will want to maximize the protection of your valuable personal and practice assets (not just the real estate) and minimize unnecessary tax liabilities.