Renting a property, whether a residential or commercial rental, is generally considered to be a high liability business. As a result, reducing the possibility that creditors (which could include an aggrieved tenant) can reach your other assets is critical. That is done by separating each rental property from your other assets – including from any other rental property.
One way to separate is to put each property in a limited liability company (“LLC”). LLC’s provide liability insulation and protect and shield personal assets from creditors. Plus, an LLC is easy to create and administer, along with offering a significant layer of liability protection.
Don’t forget that there are other important factors as to the choice of entity, the most important of which is tax treatment. Always see your accountant for tax advice before you create any entity, such as an LLC or corporation.
If you do not have your rental property in an LLC and you lose a lawsuit by a tenant or someone injured on that property, they can record a judgment that must be paid off before you transfer any of your real property. To collect that judgment, your personal assets can also be taken, and they can also garnish your wages. Another way to lessen that probability is to be adequately insured, so contact your insurance professional for coverage options.
If the property is in an LLC, the judgment winner can generally only reach the assets of the LLC (which are usually few and illiquid), and ultimately only the amount of capital that the owners (called “members”) each contributed to the LLC.
In addition, if you have multiple owners in the rental property and you do not have an LLC, if any of the co-owners are sued (for a medical bill, car accident, etc.) the person winning the lawsuit can place that judgment lien on the property. Then the property cannot be sold or refinanced until the judgment lien has been paid, which can be costly in time and money.
If you put a rental property into your living trust, in general, a living trust does not provide asset protection, as the creditor will have access to all of the assets in the trust. If the property is in an LLC, the winner of the lawsuit is limited to what is within the LLC. Any other assets of yours, whether or not in trust, cannot be touched.
By setting up an LLC to own your rental property, it takes your personal name off title of record and may provide a level of privacy (but don’t forget that §33-1902 of Arizona law requires rental property owners to provide some basic contact information).
There are also tax considerations: The earnings of an LLC “flow-through” to the members, and are taxed only once at the member level, on the member’s tax return. Besides, accountants tell me that creating an LLC and a separate business checking account for LLC cash reduces the chance of getting audited by the IRS. Certainly that separation of personal and business assets would make any audit much simpler and winnable.
Finally, an LLC affords the greatest flexibility among all other entity choices in terms of management structure, operations, and allocation of profit and loss. Also, transactions including 1031 exchanges, refinancing, and selling are usually easier to accomplish with an LLC – especially if there are multiple owners.
But the paramount factor for rental property owners, is that now more than ever, they are under increased liability exposure to renters and their guests, and from trade obligations including those of vendors and contractors. An LLC does a great job of providing a shield to prevent any successful creditor from reaching your personal or other real estate assets.