You've saved for the down payment, picked out a neighborhood, and found a good house at a solid price. You’re ready to purchase a rental property. But once you’ve bought the property, are you protected legally against the liabilities that come with renting it out?
A limited liability company (LLC) and an irrevocable trust are two of the options available to protect you against some of the risks. Here's how to find out which one is best for you.
The LLC Option
An LLC is an entity you can own solely or partially. You don’t need any employees in the LLC besides yourself, and you don’t need a board of directors, which is often a requirement for corporations. Establishing an LLC separates your personal assets from your business assets and protects you in legal disputes. You can give property to your LLC, and if it runs into financial or legal trouble, people cannot seize your personal assets to pay off any debts. It’s also difficult to use the assets of the LLC for personal gain or use.
However, if it is proven you did something illegal with your LLC, your personal assets are fair game. You need to be able to prove your LLC is conducting business and not being used as a place simply to hold your personal assets. There are other regular events that must occur to prove you’re using the LLC for business purposes, including filing tax returns, holding annual meetings, etc.
To establish an LLC, you have to file legal paperwork, pay a fee, and create an LLC operating agreement.
There are two types of trusts, irrevocable and revocable. In the case of an irrevocable trust, as soon as it’s made the creator ceases to have control over the assets of the trust. Only the trust’s beneficiary can make changes or dissolve the trust. On the other hand, if you create a revocable trust, you still have the power to make changes.
One benefit of a trust is it doesn’t count as part of the guarantor’s personal assets. If you’re trying to mitigate your estate tax burden, putting money in a trust can decrease the value of your personal assets.
What the Pros Suggest
CFP Johanna Turner of Milestones Financial Planning recommends using an LLC for their rental real estate. However, using one LLC for all your real estate can be risky, and using separate LLCs for each investment is expensive, complicated, and unnecessary.
Turner has a different solution: “One way to manage this problem is to buy an umbrella liability insurance policy,” she said. “The best solution is the Series LLC (SLLC), a fairly new organizational structure that provides liability protection across a series of investments that are segregated from each other but operate under one umbrella for liability and tax purposes.”
CFP Chris Hardy, talks about the benefits to choosing a trust instead of an LLC: "A trust provides an extra layer of privacy since all the filings will be in the name of the trust," he said. Another benefit of a trust is it can help the guarantor avoid paying estate taxes on the property.
The Bottom Line
Neither a trust nor an LLC will cover you completely because renting is a liability-filled business with lots of potential problems. The protection they offer is still substantial, though, and a good idea for any potential landlord. Anything you can do to minimize the damage is the worth the time, effort and money.