Do rental properties need to be placed in an LLC, or is having liability insurance sufficient to hold the property in your personal name?
Background Scenario
Far too often, individuals who purchase, inherit, or are gifted a rental property, or simply convert a residential property used for their personal use to a rental property, report the rental activity on Schedule E of their Form 1040. In other words, they own the rental property in their own name and dismiss having a limited liability company (LLC) own the rental property.
Why Individuals Own Rental Properties in Their Names
One could argue that individuals put the title of their rental properties in their own names because they are ignorant of the liability issues associated with such a move; they wish to avoid the additional costs associated with owning an LLC; or they believe that increasing the liability coverage on their insurance policy will adequately protect them.
While we will discuss all three of the above reasons, the focus of this post will be on the third reason, the misconception about insurance coverage.
Brief Overview of Liability Issues
Owning a rental property is not without risks. A tenant or a customer in a retail operation could have a slip and fall, and sue the owner of the property for negligence. The landlord may have a dispute with a vendor or supplier, and that could result in a lawsuit for breach of contract. There are other ways in which a lawsuit can be the end result. How or why the suit is filed is not our focus. Rather, the focus is on one step that can be taken to limit the landlord’s liability exposure – – – have the rental property owned by an LLC.
If the property is owned directly by the individual, all of the individual’s assets are conceivably at risk. If the property is placed in an LLC, a properly structured LLC should limit the liability to the assets of the LLC and protect the landlord’s personal assets.
We believe that most individuals would agree that it would be best to own the rental property in an LLC. But, why do they own the properties in their individual names?
Additional Costs of an LLC
There is no question that an owner of a rental property will incur additional costs to have the LLC own that property rather than owning the property in their individual name. While not all-inclusive, those costs would include the legal fees associated with the formation of the LLC with the Secretary of State and the writing of an operating agreement, the filing of tax returns and possibly annual returns, bookkeeping costs as the books and records of the LLC must be kept separate from the owner’s individual accounting and tax records, and separate tax return preparation and filing fees to name a few of those additional costs. Initially, those additional costs can run in the thousands of dollars.
If there will be a mortgage on the rental property, the lender will charge the higher commercial interest rates as the LLC is a business entity and not a residential property subject to more attractive rates.
If the owner of the property wishes to transfer ownership from their individual name to the LLC, and that property is located in Pennsylvania, the owner will have to pay the two per cent realty transfer fee. In this scenario, the owner incurs additional costs that can run in the thousands. If there is debt on the rental property, the owner will very likely need to refinance the loan, incur re-financing costs, and be subject to commercial rates.
When faced with the decision of having to spend thousands of dollars to have the rental property in an LLC, the often shortsighted thinking is to quickly dismiss the LLC option and own the rental property in the name of the individual and simply purchase relatively inexpensive additional liability insurance to cover a claim.
The Solution is Not Simply Buying Additional Liability Insurance
Let’s be clear. The first line of defense when a lawsuit is filed is to have adequate liability insurance. Landlords should consult with their insurance broker and determine the adequate amount of liability insurance to carry. If the insurance carrier allows umbrella insurance coverage on the rental property, that is an additional consideration to ponder.
When speaking with the insurance broker, be sure to discuss and thoroughly understand the exclusions from coverage. Far too often, the exclusions in the insurance policy are not read or are quickly dismissed as not important or will never be relevant.
Some possible exclusions are, but not limited to . . .
Toxic mold. Any water leak is susceptible to mold intrusion. If mold develops or is found within the rental property, many policies exclude mold remediation and other environmental hazards. If covered, there is generally a dollar ceiling on that coverage.
Covid-19 pandemic. We just experienced a Covid-19 pandemic. If the rental property is deemed a “sick building,” and the tenants, or contractors engaged to remediate the building fall ill to Covid-19, it is likely that the insurance policy will not cover potential respiratory infection suits.
Vacancies over 30 days. Insurance policies have extended absence exclusions. For example, if your rental property is vacant for say 30 days, and an incident occurs during that vacancy that would normally be covered, is that incident no longer covered due to the extended absence? In addition to normal vacancies after one tenant moves out and the landlord searches for the ideal future tenant, vacancies can occur if a tenant trashes the rental property and it requires extensive rehab work, or is vacant due to the previously mentioned pandemic or environmental hazards.
Reduced rents for services rendered. It is not uncommon for a tenant to barter with a landlord. For example, the tenant agrees to provide some repair or to perform maintenance work in exchange for a reduced rent. State law may treat those tenants performing that work as an unlicensed contractor or as your employee, denying coverage should the tenant incur an injury.
Vicious dog. A tenant ignores the landlord’s rules and regulations and brings a dog into the building and that dog bites another tenant, visitor, or vendor. If that dog is considered a vicious dog by your insurance carrier, those dog bites are not covered.
Related to the above potential insurance policy exclusions, if a claim is filed and since your likely personally guaranteed the loan on the rental property, or if there is insufficient rental income to service the debt on the property, you may have inadvertently exposed your personal assets due to that personal guarantee. Have any of these events caused the fair market value of your rental property to decrease? If the property declines in value, or there any loan provisions related to debt to fair market value ratios that could trigger a personal guarantee?
If the rental property were held in an LLC, your liability exposure may have been limited to the assets within the LLC.
Final Comment
Owning a rental property is not without risk. We believe everyone agrees with that premise. The point we are making is that while the up-front costs of creating an LLC that will hold your rental property may cost a few thousand dollars, in the long run, it may be the most cost efficient way to own rental property.
When entering into a new business venture, in addition to the creation of the business, you also need an exit strategy. What are your future plans for this business? How will you exit from this business enterprise? Perhaps having the rental property in an LLC would better serve you when the property is sold, gifted, or exchanged.
When purchasing a rental property or converting a personal residence to a rental property, consult with a real estate attorney, an asset protection attorney, an insurance broker and an experienced tax professional.
Tip #1
When considering limited liability options and associated costs, you need to look at both the short-term and long-term ramifications of that decision.
Tip #2
To repeat what was stated above, when considering investing in a rental property, consult with a real estate attorney, an asset protection attorney, an insurance broker, and your tax professional. As part of your exit strategy, you may wish to include an estate planning attorney.
If you would like to discuss your business or personal tax planning, tax preparation and other financial concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
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BE SURE TO READ THE DISCLAIMER PAGE: Tax laws, IRS rules and regulations change frequently. Although we hope you’ll find this information helpful, this blog is for educational purposes only and should not be considered as the rendering of tax, legal or investment advice. The publisher shall not assume liability for any losses, injuries, or damages from the display or use of this information.
About F. Bryan Haarlander, EA, CTRS:
Bryan Haarlander is an IRS licensed Enrolled Agent and who owns and operates a specialized tax services firm serving clients in the western suburbs of Philadelphia, PA, which includes the cities of Chester Springs, Coatesville, Collegeville, Devon, Downingtown, Exton, Frazer, King of Prussia, Paoli, Philadelphia, Phoenixville, Pottstown, Radnor, Reading, Wayne, West Chester in Berks, Chester, Delaware, Montgomery and Philadelphia Counties, as well as clients in Delaware, New Jersey, New York and throughout the continental USA.
A Certified Tax Resolution Specialist, Bryan is well-known for his IRS tax resolution expertise and his book How to Resolve Your IRS Tax Debt Problems.
