An investment property is real estate that is not your primary residence and is purchased or used in order to generate income by appreciation, leasing, taking advantage of tax benefits or other uses.
As corporate vehicles go, the LLC (limited liability company) protects its owner-members’ personal assets and allows for flexible profit distribution, making it a very useful vehicle for owning an investment property.
Protection from Personal Liability
The primary reason to form an LLC is for the legal protection it offers. A rule of thumb is to think of it this way: “liability follows the property owner.” It follows that if a LLC owns the property, the LLC is responsible for any liability resulting from the property. Thus, when used properly the LLC will “shield” the individual owner’s personal assets from the LLC’s liabilities, debts and obligations.
For instance, let’s say that you are property owner renting out your investment property to a tenant and the tenant severely injures herself. After a flurry of demand letters from her attorneys asking for hundreds of thousands of dollars, she sues. If the investment property is owned individually, then the tenant will be able to recover damages against the personal assets of the property owner. Now, if the investment property is owned by your LLC, the tenant will only be able to recover damages against the LLC. Those damages would be limited to the assets owned by the LLC – the real property, money in bank accounts, etc. But, that’s where the damages stop thereby protecting the individual owner’s life savings.
As a property owner, your first level of protection is liability insurance. But insurance companies are always looking for reasons to avoid having to pay your claim. Because of the limited liability protection if affords the property owner, the second level ought to be owning the property in a limited liability company.
Maintaining Corporate Formalities and Operating Properly
In order for the LLC to protect the owner’s personal assets from the debts and obligations of the LLC, it must be formed and operated properly.
Filing Articles of Organization with the Arizona Corporation Commission is how we form an LLC, but that’s not the end of the story. The LLC owner actually has to run the LLC like a business – with it’s own bank account, tax identification number, internal documents and records and above all not commingling the LLC’s assets with those of the individual owner. Here’s some common issues we’ve seen:
1. No operating agreement or other important company records. Courts look at these things to determine whether or not the LLC is an actual business or a mere shell or the “alter ego” of the individual owner. If the court decides the corporate formalities aren’t present, it may allow the creditor to “pierce the corporate veil” and get to the owner’s personal assets. Read more about why every LLC needs an operating agreement.
2. No company bank account or tax identification number. These things are required to operate a legitimate business.
3. Not deeding the property into the LLC. Forming an LLC is the first step, but you must take steps to transfer the property out of your name and into the name of the new LLC. If the property isn’t in the LLC, then the LLC isn’t protecting the owner’s personal assets from potential liability.
4. Using the LLC’s assets for personal expenses. It’s a business, and so the LLC’s assets should only be used to pay for legitimate expenses related to the business.
We cover all of these issues with our LLC clients to ensure that all necessary steps have been taken to protect the owner from the LLC’s liabilities. We’ve not only formed many LLC’s for our clients, we have also litigated these matters, giving us a unique perspective from which we advise our clients. Please call us to discuss how forming an LLC can protect your personal assets.