Umbrella Policy or LLC? An Asset Protection Guide for Real Estate Investors

This is an interesting question and depending on who you talk to will probably result in dramatically different answers. Attorneys tend to push for the Limited Liability Company (LLC) more than necessary, and insurance brokers tend to push for more insurance coverage than necessary. Therefore, some people will advocate for a “belt and suspenders” approach of having both a high amount of liability insurance and an LLC. Well, the cost of both insurance and an LLC ($800/yr in CA) plus the cost of a property management firm (8 – 12% of the monthly rental value of the property, plus expenses) will significantly decrease the profitability of your properties. A lot of investors form an LLC as a magic solution. A few clicks of the mouse on Legal Zoom, pick a cool sounding name, get some business cards and website, and suddenly you have your foolproof LLC. This is the reason most estate investors want an LLC. Limited Liability means that owners of an LLC cannot be held liable for acts or debts of the LLC. If the LLC is sued, the plaintiff could potentially win a judgment for the value of everything owned by the LLC, but the plaintiff can’t go after the financial assets of the owners of the LLC.

So, let’s take a step back and explain what an umbrella policy is. An umbrella policy is an additional layer of protection on top of your existing insurance policies. It provides protection against a wide variety of perils across all your assets. Let me give you an example:

Chad owns a rental property with $250,000 of equity and has a landlord policy with $500,000 of liability coverage and an umbrella policy with an additional $1,000,000 of coverage ($10k deductible).  The current tenant has a party with people on the upstairs balcony. The balcony collapses, causing serious injury to 7 people. Chad gets sued for $1,650,000. The first layer of protection is the rental dwelling insurance covering the first $500,000. After paying the $10k deductible, your second layer of defense, the umbrella policy, pays the next $1,000,000. Chad would then be left with a total out-of-pocket liability of $150,000.

When reviewing my client’s insurance policies, this is a risk exposure that tends to be underfunded and tends to be the least understood. Not all umbrella policies are the same, and these are insurance companies and not charities. So, they are also in the business of risk, so they will exempt and/or exclude items that you assumed were covered. It’s best not to wait until a claim is filed before figuring out if it is covered. With that said, there are (3) great advantages to having an umbrella policy:

  • Protection that travels with you – An umbrella policy provides a very comprehensive layer of protection against threats you might not have any protection from today. It provides insurance against incidents that happen away from home (your dog bites somebody in a park), libel and slander, and a variety of threats to your finances that aren’t protected through other mechanisms.
  • It is cheap and simple – I’ve found coverage for a $1,000,000 umbrella policy for as low as $250/year, and the cost goes down the more coverage you seek. Coverage for a $10,000,000 umbrella policy is available around $1,000/year. It is also really simple to manage. One check, one company, for covering both your personal and business (rental properties) liabilities.
  • Covers all your properties, regardless of location – An umbrella policy will cover all your rental properties throughout the U.S., regardless of what state they are in. An LLC is specific to the state it’s formed in. If you have an LLC formed in California and you want it to operate in Texas, you’ll need to file paperwork (and pay fees) to register the LLC in Texas. If you’re going to file paperwork to allow your California LLC to operate in Texas, you might as well just create a new LLC in Texas and have a bit more protection.

Remember the first layer of protection as a landlord is through your rental dwelling insurance policy (landlord policy). Note that a rental dwelling insurance policy is a different policy from the homeowner’s policy that you have on your primary residence. A homeowner’s policy insures not just your house, but also your furniture, clothing, etc. The rental dwelling insurance policy only covers the actual structure, but it does provide higher liability insurance. It’s also important to note that your insurance company provides legal representation in addition to the stated coverage and your insurance company has no incentive to negotiate a settlement at any amount over their stated coverage. This means that you’ll still need to hire a lawyer if you’re sued for an amount greater than your landlord policy + umbrella policy. I recommend my clients require that their tenants carry renter’s insurance. A renter’s insurance policy will cover their possessions as well as provide some liability insurance for incidents that happen on the property that they are responsible for. If the renter has insurance, there is less reason to go after you and their insurance means you’re less likely to be sued.

Since the most likely scenario is one where there are no issues and no claim, the vast majority of individual investors are better off with an umbrella policy. If you have lots of individual rental properties, then the LLC fees could eat into your profits if you have a separate LLC per property. The fees vary from state to state, and some are more expensive upfront, some are more expensive each year, etc. There is an initial filing fee to set up the LLC, an LLC formation fee ($200-$1,000), and a licensing fee for each year the LLC is active.

  • Arizona – Both low initial cost & low yearly cost
  • Texas – High initial cost ($300), No yearly cost (assuming revenue <$300k)
  • California – Low initial cost, high yearly cost ($800)

But you can’t be cheap and try to cram multiple properties into a single LLC because you are losing much on the protection of having an LLC in the first place.

If you have a small number of large or valuable properties (significant equity), then an LLC doesn’t help much because most of your net worth is probably already tied up in the property. If you have a mortgage-free $5,000,000 duplex in Santa Monica and get sued, even though you had an LLC you can still lose the property in a judgment and be effectively wiped out financially.

A scenario where having an LLC makes sense is if you have lots of expensive properties. Putting each property in an LLC prevents a single large liability from wiping out your entire net worth. This is for the real estate investor who has 15 San Diego rental properties that were purchased decades ago and each property is currently worth $1,500,000. This is a net worth of $22,500,000, so you don’t want an incident at one rental property to allow a judgment beyond $1,500,000.

However, if you choose to go the LLC route there are (3) major considerations to understand:

  1. Transferring property into an LLC – Before the LLC will offer you any protection, you first have to move your properties into an LLC. This is a major inconvenience to a lot of investors. Especially if you have a mortgage and have to get the lender to agree to transfer to avoid triggering due-on-sale clause (balance of your loan is immediately due), which rarely happens. When transferring real estate, too many real estate investors opt for Quit Claim option most likely due to its common parlance amongst investors when discussing the transfer of real estate. A Quit Claim Deed transfers bare legal title to the grantee without any warranties of any sort. Think of it like the “AS IS” clause in a real estate purchase and sale agreement.  A Warranty Deed on the other hand guarantees free and clear title of any defects. This is important because you want the guarantee that the transfer of property is valid to ensure you have the LLC protection. So go with the warranty deed.
  2. Outside Liability – An LLC will protect assets from a lawsuit against your LLC, but it will not protect you if you get sued personally (car accident for texting/driving). If you act as the property manager, there’s liability from that as well. Maybe you didn’t warn the new tenant about an issue with the property when they moved in – you’ll be sued as the property manager AND your LLC will be sued as the owner. Most importantly, an LLC is a business entity. So, function like one or a plaintiff attorney can try to “pierce the corporate veil” and flow a lawsuit directly to a personal judgment. This means having separate books, LLC bank accounts, annual compliance (holding yearly meetings, documenting them with contemporaneous meeting notes, formally passing new bylaws, etc.). There are paralegals who will do this for $200.
  3. Anonymity – Some landlords don’t like the idea of tenants knowing who they are or where they live. Especially when dealing with the prospects of raising rents and evictions. So the LLC can be used to provide an initial layer of anonymity. Real estate ownership is public record, so it’s not too complicated to find out who owns a given parcel. You can go down to the county recorder’s office or pay for third-party online search services. So by transferring ownership of the property to the LLC, a property search will reveal the LLC as owner. So don’t use your name for your LLC. Make it abstract like Red Leaf Development. If a potential Plaintiff does some additional digging, it is not hard to find out who the owner of the LLC is. This is common when you’re the registered agent and/or the LLC address is your home address and has completely blown your anonymity efforts. You’d need to set up a third-party to be the registered agent and rent a PO Box to use as the mailing address for your LLC. Lastly, if you’re also acting as the property manager (or otherwise involved with the property) and/or have a mortgage lien in your name, then any anonymity measures will be trivial.

I’ve been in the personal finance field for about a decade, and I continue to see asset protection strategies for prospects as a significantly overlooked part of the comprehensive financial planning process. If you have rental properties or any corporate entity, it is important to understand your exposures, layers of protection, & have them reviewed.

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