Protecting your assets should be a critical part of your investment program. Years ago, we had several reasons not to worry too much about it. Here were some of my excuses:
1.) The old “can't get blood out of a turnip.” If you don't have any assets, there's not much for them to get. When getting started, I usually didn't have much cash and not much equity. Not much there means not much for them to get. It felt safe.
2.) Insurance was labeled as the first line of defense in the asset protection arena. Buying good insurance and a lot of it was considered an acceptable way to “buy” protection.
As a real estate investor, it's easy to focus on the “deal” and the “numbers” involving the performance of our properties. Capture another deal and you'll feel great and share the details over dinner and with your friendly competition. Put a few of these in your pipeline and before you know it, you're one of those folks with something others might want to go after. Simply allowing yourself to be known as a “landlord” or real estate investor implies you have a lot of assets, deep pockets, and plenty of cash.
Before you know it, you might have become a bigger target than you could've ever imagined, all from the result of your work, effort, and continued education and knowledge. Protecting your assets becomes a number 2 quadrant activity of “not urgent, but important.” We all just procrastinate. There's not much excitement in figuring out how to protect your self. It's not as much fun as doing a deal, cashing a big check, or collecting payments every month. It's b-o-r-i-n-g and usually involves having conversations with boring professionals who have their meter running charging you to talk with them. Ouch! Developing an asset protection plan is about as much fun as going to the doctor or dentist.
Let's try it using the KISS method.
First of all, let's try a simple comparison. Let's use a good sharp fast sports car. This sports car has the best and biggest 12 cylinder engine with the most horsepower. It's powerful. It can go from 0-60mph in 3 seconds. This sports car has the best and smoothest transmission. It's just a well-built and very fast and sharp car. Sounds good so far, right? What if you put 4 different size tires on this car because they're cheaper or somebody told you to do it this way? Wouldn't this affect the performance? What if you failed to keep the proper air pressure in all four of your different size tires? What if you never changed the oil, air filter, anti-freeze? What if the car called for high octane fuel and filled the tank with diesel fuel or kerosene because it's cheaper?
I don't know much about cars and really don't plan on learning anytime soon; however, I hope you can see how your high performance sports car could be turned into junk in short order without proper preventative maintenance. The same applies to protecting your assets. When gathering information to learn about something, learn from somebody who has been there and done that. Would you want to learn how to be a millionaire from a guy who speaks well and works at a temp service making 20k annually? Would you go to a veterinarian for brain surgery because they're your buddy and will do it cheaper?
It urks me to see investors start off wrong with bad information from a trusted friend who happens to be a professional. Be careful. Yes, I'm picking on attorneys and CPA's because this happened to me too. These “friends” meant well and really truly were trying to help; however, they were not experts in the real estate investing arena. Protecting your assets involves several factors. Just like the sports car, there are many parts to make this work properly. Proper tires, fuel, driver and other parts all combined properly = good sports car. There is no one button to push fixes everything. It just doesn't happen so easily.
For starters, many folks say “I don't want to own anything. If I don't anything, I have no liability.” boloney! The only way to remove all personal liability on your part is to get off the planet. You could own absolutely nothing and if you're driving your neighbor's car to the grocery and run over the little old lady pushing the buggy in the parking lot, guess who'll get sued? The owner of the car and the driver…you! So, bite your lip. You can never remove all liability. This kind of exposure will be called the “back door.” When you get sued from the “back door,” and they win, they get insurance money first. Then they'll get the things you own or have an interest in to satisfy a judgment. It's just plain ugly.
Protecting Your Assets Involves 3 Concerns
- Tax Strategies
- Estate Planning
These three concerns each have unique and effective strategies for each benefit; however, as shown in the drawing above, they overlap each other. They don't always compliment one another. This drives us absolutely bananas. When discussing protecting your assets with your CPA, they will almost always defer some questions to your attorney and vice versa. The point is, if you structure everything for the simplest and best tax strategies, it'll probably violate and may not be the best for asset protection and/or estate planning. If you get a super aggressive estate plan put together to make things easier for your heirs, I'll bet you've made things worse for your tax situation right now. (I did).
After a lot of research, expense, and growing pains here's the simplest plan. Take title to property using a land trust. A land trust simply hides the beneficial interest from the public record. It does not exist for tax purposes. It should not cost you a penny extra in closing costs.
Use “Single Member, Manager Managed LLC” (limited liability company) for ownership of investment property. If set up properly, these entities do not exist for tax purposes. They exist only for liability purposes. Treat them like a business for liability concerns including a bank account for each LLC, but everything gets combined and reported on your personal tax return as if they didn't exist.
As a rule of thumb, multi-member LLCs aren't good. They cause you to file another tax return. More tax returns equal more expenses for you. The same benefit of the multi-member LLC can be achieved using a land trust with a 50% beneficial interest for each single member LLC to replace a multi-member LLC with two members. With a 3 member Multi-member LLC, simply have each beneficial interest of 33%. The Single Member, Manager Managed LLC gives you the best of both worlds. Used properly, it gives you the benefit of the old limited partnerships without the added expense of another tax return.
In-House Property Management Company
Depending on the number of properties and your activity, you may consider a LLC to be your own property management company. This entity can be used to wholesale property and will be your “dealer” entity for tax purposes. Caution: The management fee paid to your own management company will be earned income and not passive. Earned income pays more income tax. This entity should not own assets. It's your out front entity with all the exposure, risks, and owns nothing.
Have a policy for each property. The old-timer's strategy of a good asset protection plan is to simply have good insurance, and a bunch of it. Good insurance might not be the best protection and is not the cure all today. Today, insurance companies are bailing out and backing off all kinds of coverage. They're dumping mold and mildew, lead based paint, acts of terrorism, war, and radon. Investors and homeowners are getting policies canceled because of certain species of dogs, trampolines, and even macaroni and cheese in a pot on the back porch. The list is getting longer and longer. Insurance is something you gotta have, but you better not use. If you file a claim you'll get on the nasty list and your rates will go up if not canceled first. Save insurance for tragedies such as major fires, tornadoes, hail damage. Do not use insurance for vandalism, thefts, and bad cooking.
Increase your deductible to $1,000 or $1500. If you file a claim, your rates will go up or you'll get cancelled. There is one type of insurance coverage that does not gig you personally. Weather related tragedies such as hail, tornadoes, hurricanes, etc. are labeled “catastrophic” by the insurance companies and are not a reflection on your risk as an insured. If you go overboard on your deductible to lower premiums, and raise your deductible to $5,000 or more, you'll miss the boat on hail damage and other catastrophic weather incidents.
Pay attention to your liability coverage. All the attorneys on TV are looking to help somebody sue somebody. Good insurance with good liability coverage and an umbrella policy as a back up plan are good front line defenses for you in the liability department. As an investor, your liability coverage should be a minimum of $1,000,000 or more.
Loss Of Rents
This highly promoted coverage is okay in the beginning with a just a few units. It's great if you have a multi-family building with 4 units or more in ONE building. For example, a building with 18 units would be a good candidate for Loss of Rents coverage. A fire or major casualty loss could cause the whole building to be vacant overnight. This coverage would be a great lifesaver here. On single-family homes as rentals, you need to do the math. When you have 20 units or more, look at the added cost of the loss of rents coverage for each and multiply it by the number of single-family homes. The benefit to the insured is usually up to 6 months of rents paid. You'll get to a point where the added cost to your premium exceeds your 6-month rent benefit. When this happens or gets close, whack it. I learned this from my insurance agent. Don't confuse with multi-family.
Also called “excess liability” coverage. This can be an ugly monster if not understood. Remember, insurance agents usually work on commissions. They want to sell, sell, sell. Umbrella Policies got their name by the way the policy operates. An umbrella policy does not cover everything and all of your loose ends. It covers what is only under the unbrella. If you have a policy with insurance company A, and you have an umbrella policy with Company B, odds are your umbrella won't cover or stand behind company A's coverage, especially if you fail to tell them about the Company A policy.
Agent / Company
Having one competent agent for your insurance concerns can be a huge benefit for you. Sure, they can go belly up, lose your business, and you can switch companies; but you're less likely to hiccup, hit a pothole, or forget something like those umbrellas. It will eliminate the need for two or more umbrella policies and the added stress of making sure all of your properties and activities are included under the two or more umbrellas.
Imagine for a moment you have two or more insurance agents and companies. Insurance Agent A, B, and C. Each agent has policies covering some of your properties. Each has an umbrella for their policies. You are an aggressive real estate investor and you buy and hold with tenants, and buy and sell some to feed the machine. What a mess! Odds are you will get gigged on extra premiums and you must always remind your agent A, B, C to add / delete properties on regular insurance and each umbrella. Now, suppose you have one agent with Company A. Easier for me, easier for them. You can structure your umbrella to cover all policies with Agent A. No need to worry here. If you choose not to use an umbrella policy, you better load up real good on the front policy. I suggest again, a minimum of $ 1,000,000.
You can argue this one all day long. It's absolutely easier, safer, and more efficient to have a separate policy on each property. Do not get a commercial policy adding more units, buildings, and etc. all on one policy. This makes it easier for the agent and horrible for you. It actually reduces your coverage!
- Each property stands on its own policy and it's own deductible.
- Each property with its own policy covers you better.
- Provides you with greater privacy protection. Lenders receive only proof of insurance for the one property listed. If you have a hard money lender or a seller financed property requiring proof of paid insurance, they receive only the policy for the property. If you use the agent friendly commercial policy, they will receive a list of everything you own.
- Allows you better control, especially on jumped loans. (subject to)
- Lawsuit Time: not if it happens, but when. When it does happen, one of the first things the attorney asks for and will receive without your consent is a copy of the insurance policy. Once again, the dirtbag attorney may receive a list of all your properties.
- Houses and garages may be listed as individual buildings. It can be cumbersome keeping track of building 36 and 37 in relation to addresses, especially if you sold some of them.
- Better Coverage: with each property having its own policy, each has a deductible and a liability limit. The liability limit usually has 2 numbers. The first is the limit of each occurrence. The second is the total aggregate for the policy. In simple terms, if you get sued they may pay up to the first limit for each occurrence. If it happens again during the same year, they may pay again providing it does not exceed the second number. With the commercial policy listing all of your properties, you still have a first number and a second number, all on one policy. So if you get sued, they may pay up to the first number for the first occurrence. If it happens again during the same year, it could totally wipe out your liability coverage on all of your other properties.
- Payment of Premiums: with individual policies, premiums are usually paid a year in advance. You'll have staggered premiums due throughout the year for better budgeting. A commercial policy zaps you one time annually and properties added and deleted throughout the year have pro-rated premiums based on your effective date. It's a mess if you're busy.
Jumped Loans – (Subject To)
Investors have been told “add your name to the existing homeowner's policy.” Dangerous! We're real estate investors, not homeowners! Remember, agents make their money by selling, and earning commissions. How many homeowners' policies have liability coverage of $1,000,000? The policies I've seen have jewelry, boats, minimum liability coverage, and all kinds of garbage you don't need. plus, it usually costs more.
If you've jumped or bought subject to on a property with a delinquent loan, odds are they're in a “forced insurance” plan at the direction of the lender. Super expensive, their forced insurance is usually 3 times the cost of good insurance with absolutely no liability coverage. None. Why in the world would you want to continue this policy and add your name as additional insured? Crazy and Dangerous!
Again, use your agent and get your own individual policy for the property adding the seller(s) names to your policy as “additional insured” to satisfy the lender. Don't try to argue and say something like, they have good insurance and it's being paid from escrowed funds. As investors, we're tightwads, but the purpose of insurance is for tragedies. So what, the worst-case scenario is you may pay for two policies the first year you bought the property. After you get everything squared away with the lender and correspondence coming to you about the loan, if insurance is paid from escrowed funds, cancel the existing policy purchased from the sellers and replace with your policy. They'll do it most of the time as long as the borrower(s) name(s) are on the insurance policy.
This simplified version of protecting your assets should not cause more expense from additional tax returns. Protecting your assets doesn't address any issues regarding estate planning; but, make yourself aware of how each of the 3 concerns overlap and violate each other if each is done properly. So there is no one simple plan to fix everything. Just like the fine tuned sports car, protecting your assets involves several pieces and parts all working together properly.