Disclaimer: This post is not legal advice, and simply my thoughts when it comes to asset protection and my situation. Please make sure you talk to a qualified asset protection attorney for personalized legal advice.
When it comes to asset protection for buy and hold rental properties, there are alot of differing opinions when you ask experienced investors on various forums and speaking engagements. Many people talk about entity formation, and while I personally also have a structure in place, below are 5 other ways you can protect your investments from the threat of liability:
1. General maintenance of your properties
As a savvy real estate investor, you may be focusing on the numbers when buying, rehabbing, renting and scaling your rental portfolio. However, if you are purchasing properties with a lot of deferred maintenance you may be walking a slippery slope. By becoming a responsible landlord and staying on top of routine maintenance (e.g. removing large trees around foundation, caulking around the bathroom tub, ensuring tenants replace HVAC filters and cleans the gutters), you are taking good preventive measures. Furthermore, doing a thorough job vetting your team such as your property manager, third-party contractors, and real estate brokers/agents will make a big difference in your liability exposure. Some of these parties are an extension of you and your company, and you want to make sure that you are being represented accurately, especially when working on building a portfolio out of state.
2. Cash Reserves
In order to ensure that you can protect your investments, you need to ensure that you have sufficient cash reserves to cover maintenance and capital expenditures, as no one will know for sure when these may arise. Maintaining reserves is a focal point of many lenders as such, investors who use leverage and borrow to build their rental portfolio may already be carrying a reserve balance. However, generally speaking, since there is no policing or "cash management" of your business by these lenders, it may be easy to start putting your hand into the reserve cookie jar when you think you have a lead on a great deal. It will become more important to stay disciplined and review your balance sheet when your portfolio grows to 10, 20, 30+ units. For example, you may be able to withstand 1 HVAC replacement at $5,000, but if it occurs at the same time across 5 properties, that is $25,000 that you have to account for (and trust me, I have seen it happen to my colleagues). If you have properties that generally have 10-15+ years of useful life on large CapEx items, you may consider reserving less than if you had rentals that have many properties with a roof, HVAC, water heater and plumbing that is showing signs of significant wear.
Reserves not only apply to capital expenditures and maintenance, but also in times of physical and economical vacancy. When the property is physically vacant, it means there is nobody living there, as such you may be paying the mortgage, utilities, and other fees associated with upkeep of the property until a new tenant is leased. In other cases where you have a non-paying tenant, or below market rents, you have an economical vacancy. On top of the mortgage that needs to be paid, now you may be dealing with damages to the property, eviction costs, and other legal fees associated with the turn.
There is no science when it comes to cash reserves, as such you may find investors use a percentage of gross income, or a flat dollar amount per rental unit. As you gain more experience, you will be able to adjust your risk tolerance and create contingencies to ensure that you are prepared for these unforeseen circumstances. Always hope for the best, but prepare for the worst.
3. Lines of Credit
In addition to having an adequate cash reserve, a line of credit may be a great complementary tool that can protect your assets. As mentioned in previous posts, investors have historically used various financing methods such as a personal/business line of credit or a home equity line of credit (HELOC) to conduct their acquisitions. In the same manner, investors can use an unused line of credit as an emergency line to be used to fund the business on an as needed basis.
Establishing a line of credit can be fairly simple and low cost. Furthermore, they generally have lower interest rates when compared to consumer products such as personal loans and credit cards. Depending on the product, it is generally easy to borrow or "draw" from the line. I personally opened a HELOC for this very purpose and keep a balance less than $5,000. My main use of this line is for emergency funds as I believe in the velocity of capital and putting my money to work in efficient vehicles such as real estate. As such, I am basically taking the $30,000 I would have placed in my savings account and deploying them in my business, while having a $40,000 HELOC to draw down from in case of an emergency.
One very important caveat is that if the market takes a downturn, the banks may choose to "freeze" the lines of credit, and not allow the investors to draw down new funds from the line. As such, you want to make sure that you are not 100% dependent on the line of credit as a safety net and find yourself trapped, if and when the banks decide to freeze the line.
4. Umbrella Insurance
You may have heard of an umbrella insurance to supplement your landlord policy that is attached to each property. An umbrella insurance policy provides protection beyond your primary residence, auto, and even civil lawsuits. A huge benefit of getting umbrella insurance is the affordability compared to the comprehensive coverage it provides. For example, investors have typically been able to get $1-2 million dollars of coverage for as little as $3-500/year.
In a litigious society, it is important to protect your life from predatory lawyers and their lawsuits. However, there are certainly drawbacks when it comes to umbrella insurance. As with any insurance policies, umbrella insurance has deductibles that directly correlate with the level of premiums being paid. For example, the $2 million dollar policy mentioned above carries a $15K deductible, which means that in a situation where the policy holder is found responsible for $115K payout, the first $15K of the liability will be out of pocket before the insurance company pays out the remainder of the $100K settlement. Most investors will set a reasonably high deductible as they use these policies as an additional safety net outside of the landlord's policy and other forms of asset protection.
5. Use of Legal Entities - LLC
Investors often use a limited liability company (LLC) to hold their rental properties. Like the word says, a limited liability company limits the liability exposure to within the LLC. By creating an LLC, you are creating a wall that defends your personal assets from business liability. If your LLC is setup correctly and there is a judgment against your business from a creditor, they can only take the assets within the LLC and not reach into your personal assets such as your primary residence, cars, cash, and other valuable property.
There are a few important factors when using LLCs to hold your rental property. Although they may limit your "inside" liability (e.g. tenant slip and fall, landlord negligence, etc.), it does not limit exposures from "outside" liability such as a car accident, and or other lawsuits caused by faulty acts of the owner of the LLC. Please consult with a qualified asset protection attorney to identify strategies to limit "outside" liability exposure.
Further, there are costs and administrative tasks that come along with owning rental property in an LLC such as maintaining separate checking accounts, annual minutes, LLC filing fees, registered agent fees, and tax filing fees. Be sure that you educate yourself and seperate yourself from the business as if it is determined that you have commingled funds or did not treat the LLC as a separate entity, you may lose your liability protection entirely through what is called "piercing the corporate veil".
In conclusion, there is more than one way to protect your hard earned investment properties, and investors need to understand how each of these strategies fit in their toolbox. As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.