This Topic Causes So Much Controversy, Confusion, and Stress for New Multifamily Real Estate Investors

There is so much bad information floating around the new investor communities about this issue.  Some of the problem is caused by gurus themselves, who don’t really understand the issue or are giving very bad advice about it.

What is this issue?

Should you own your multifamily property through an LLC (limited liability company) or just get adequate insurance coverage?

The insurance-only crowd says:

  • LLCs are too expensive
  • Banks won’t loan to you if you own through an LLC
  • There is extra work involved with an LLC
  • You have to pay extra taxes with an LLC
  • There are registration fees for LLCs
  • You need to have insurance anyway, and that will cover you. Why pay extra for an LLC?
  • LLCs are worthless because any good lawyer can “pierce the corporate veil” (i.e., get a court to disregard the LLC and go after your personal assets)

The LLC crowd says:

  • LLCs give you an extra layer of protection
  • You can save taxes by running expenses through them, so you can pay for personal items with pre-tax dollars
  • Insurance and LLCs have two different purposes

I have heard ALL of these statements from new investors at one time or another. SOME of them are absolutely FALSE.

Real estate is a business, and if you are in business you should not be operating in your own name — unless the law requires it, such as for certain professionals like lawyers and doctors who society feels should not have their professional liability limited. My knowledge is not exhaustive here, but I am unaware of any jurisdiction that requires you to own investment real estate in your own name.

People are confused because they get a lot of bad advice about LLCs — what they can and cannot do. They are told that they should not bother with LLCs because an LLC will not protect them from liability to a lender or because insurance does the same thing. I will expose the incorrect thinking below.

But first, let’s discuss what an LLC actually is. It’s a corporate form with a separate legal identity. As the name “limited liability company” implies, it limits your liability to the value of the asset. It does not eliminate your liability, so when people say you should not bother with an LLC because it does not eliminate all liability, they are confusing the issue. An LLC provides important liability limitation and risk-management capability, and if you are in business you should be taking advantage.

It is true that lenders won’t lend to an LLC with no history. If you are new, and the LLC does not have a proven cash flow, a lender will make you sign on the debt yourself.

But you should still organize your business in a corporate form, like an LLC. Why? Because banks are not your only potential creditors. Who else is out there? Practically the entire world is a potential creditor. Tenants, vendors, guests of tenants, the mailman, UPS, the cable guy — in other words, anyone who ever sells anything to the property or sets foot on it is a potential creditor. (Anyone who sets foot on the property is a potential creditor if they slip and fall on the property — or if they claim they slipped and fell even if they did not.)

If the property is owned by an LLC that you own, the LLC is the person legally responsible. If you own the property directly, YOU are the person legally responsible. If an LLC owns the property, the worst the creditor can do to you is take the property. If you own the property, and the property is not worth enough to satisfy the judgment, then the creditor will take the property AND THEN go after your personal assets — that means your house, your car, your 401(k), your children’s 529 plan, your baseball card collection, your monthly paycheck.

Insurance is another must, but it does not replace an LLC. If you have insurance, that’s great. It will cover what’s in the insurance contract, up to the coverage limit. But insurance won’t cover when you don’t pay a vendor, for example.

And what if someone is injured on your property and the court awards more than the insurance coverage? If you have an LLC, they may try to go after your assets, but they won’t be successful if you have run the business properly. If you own the property in your own name, then you should re-read the paragraph above about your house, your car, your 401(k), etc.

A very important note about LLCs is, as I said above, that they are separate legal entities. To get LLC protection against creditors, you must respect the separate legal entity. You must IGNORE the advice that some real estate gurus give, which is to run a whole bunch of personal expenses through the LLC.

THIS IS THE ABSOLUTE WORST THING YOU COULD POSSIBLY DO. Will it save you some taxes? Maybe, if you don’t get audited. Will it destroy the limited liability protection and expose your personal assets to seizure by creditors? Absolutely.  People who claim that LLCs are worthless because they don’t actually protect you are talking about this scenario.  But the stories they are referring to are the ones where someone has followed guru advice about tax avoidance and it’s come back to bite them hard.

The biggest complaint against LLCs is that they cost money. Yes, you need to file tax returns for them. Yes, you need to do proper accounting. All this is true. These are all costs of doing business.

But, remember, multifamily real estate investment is a business. You are not in it as a hobby. This is where the big boys and girls play. If you are not willing to spend a couple hundred dollars a year on LLC costs, you probably should not be in this business at all.

But the real question is: Would you rather have the couple hundred dollars extra each year that you didn’t spend on the LLC or the peace of mind of knowing that your and your family’s personal assets are not exposed just because you decided to buy an investment property?

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